Before you start looking at investment opportunities in the US, it is important to spend some time understanding the way the markets work there and factors that influence them. An essential aspect of understanding the equity market of any country is the list of stock market indices. They act like a measuring gauge that offers a comprehensive view of the market conditions in the country. They can help you identify market trends and investor sentiment without getting into individual social, political, and other macroeconomic factors. Today, we will talk about stock market indices in the US and share some essential information about them.
The US stock market is the largest in the world and one of the most evolved ones too. Before we talk about the stock market indices in the US, let’s look at some basics:
A stock market index is a hypothetical portfolio of stocks that represents a certain segment of the market. There are different ways in which an index is formed and calculated.
Primarily, indices use a weighted average calculation to arrive at their value. This weighted average can be based on price-weightage, market capitalization-weightage, etc.
If an index follows the price-weightage method, then a change in the price of holdings with the highest price will impact the index more than those with a lower price. On the other hand, if the index follows a market cap-weighting method, then price becomes irrelevant and the index is impacted primarily by changes in the price of stocks with higher market capitalizations.
In the US, there are over 5000 stock market indices. Yes, you read that right – 5000+ stock market indices. There is an index for almost any conceivable sector or segment of the economy and the market. Of these, some indices are followed by most investors regularly as they offer a clear picture of the overall performance of the US markets. These are:
If you try to watch the news about the US stock markets, you will come across these names regularly. This is because the media usually reports on the direction of these indices to highlight the performance of the equity markets in the US. As an investor, an index can work as a performance and asset allocation guide. It can also help you invest passively via mutual funds or exchange-traded funds (ETFs). Let’s take a detailed look at these indices:
The S&P 500 or the Standard and Poor’s 500 is a stock market index having 500 top companies in the US. It is a market capitalization-weighted index and offers a comprehensive view of the performance of large-cap stocks in the country. It is one of the most widely used indices in the US. While the committee that selects the stocks for the index focuses on market capitalization, it also includes factors like liquidity, trading history, float, financial viability, etc. If you look at the value of the index, it represents around 80% of the total US stock market. Hence, it can offer a good view of the performance of the overall market. The selection criteria include:
Some top names in the S&P 500 are:
The Dow Jones Industrial Average is one of the most popular stock indices in the world. It consists of 30 companies that are the most prominent in the US. Unlike the S&P 500, the DJIA is a price-weighted index. Traditionally, the calculation of the DJIA index was simple – the total price per share of the stocks of all companies in the index was divided by the number of companies. However, with time, this calculation evolved to factor in many factors like spin-offs, splits in stocks, etc.
While the DJIA represents around 25% of the US stock market (much lower than the 80% representation of the S&P 500), it is believed to be an excellent indicator of the entire market. Most seasoned investors look to the DJIA as a representation of the best blue-chip companies in the US. There are no specific rules for the selection of stocks to be included in the DJIA. In fact, the selection of stocks does not change regularly. The stocks are selected to cover a gamut of companies from industries like IT, healthcare, etc.
Here is an interesting trivia about DJIA:
‘The Dow Jones Industrial Average was created in 1896 and consisted of 12 companies. It was expanded to 30 companies in 1928’
The 30 companies in DJIA are:
The Nasdaq Composite is one of the world’s major stock indices. This index tracks the performance of around 3000 stocks that are traded on the Nasdaq exchange. It is an excellent indicator of the performance of the technological sector and includes companies of all sizes. This is a market capitalization-weighted index and includes some companies that are not from the US too. The index primarily focuses on tech companies but includes stocks from other sectors like finance, transportation, etc. Most experienced investors believe that the Nasdaq Composite Index is a great indicator of the performance of the tech sector and the investor sentiment towards this sector.
For a security to be included in the index, it needs to be listed on the Nasdaq stock market and must be:
There is a list of securities that are excluded from the index that includes exchange-traded funds (ETFs), convertible debentures, closed-ended funds, etc. Also, if security no longer meets the criteria, it is excluded from the index.
As of March 2020, the composition of the index was as follows:
The top companies in the Nasdaq Composite Index are:
The Wilshire 5000 Index is also known as the ‘total market index’. This index includes all the publicly listed companies in the US and has readily available data about their price. This index was created in 1974 and reflects the movement of the entire market. Companies need to fulfill the following criteria to be included in the index:
The TMWX is the best single measure of the US stock market.
Here is an interesting trivia about Nasdaq Composite Index:
‘When the TMWX was launched in 1974, it contained 5000 stocks. In 2020, this number has dropped to 3451 stocks.’
As you can see, the top three stock indices are based on different stock pools and vary in size too. Hence, it is important to ensure that you spend some time in understanding these indices before making an investment in the US markets.