US Stock Market Indexes

(photo by Meric Dagli on Unsplash)

How do we determine how the OVERALL stock market is doing? We can look at charts of individual stocks. However, 2,400 companies trade on the NY Stock Exchange alone. Instead, we can look at various indexes, which group together a bunch of individual stocks. In the U.S., the three biggest indexes are the S&P500, Nasdaq, and Dow Jones. I also like to include the Russell. In addition to these indexes, there are 5,000 others that make up the U.S. equity market, allowing us to dice and slice the market into many subcategories. Indexes can be constructed in a variety of ways, but they are commonly identified by capitalization (size) and sector segregation (similar businesses grouped together).

News broadcasts tend to focus on the Dow Jones, as it is one of the oldest and well-known indexes. It includes the stocks of 30 of the largest and most influential companies in the U.S. Because the Dow contains only 30 stocks, it really does not carry as much weight as the S&P500 (500 stocks), Nasdaq Composite (2,500 stocks), and Russell 2000 (2,000 stocks).

The S&P500 Index represents 80% of the total value of the U.S. stock market. Generally, the S&P500 reflects movement in the U.S. stock market as a whole.

The Nasdaq Composite Index is more technology focused, although it does include other non-technology industries, as well as some companies NOT based in the U.S.

The Russell 2000 focuses on smaller companies in the U.S. market in various sectors. The largest company in this index has a market cap of $32 billion, while the smaller ones have market caps around $200 million. This index also contains a lot of U.S. community banks. At least it did until June 2021. Every year, indexes recalibrate to remove and add companies based on how the company capitalization (size) has changed. Because bank stock prices have dropped over the past year, relative to other sectors, many banks’ capitalization dropped below the Russell $200 million threshold. I’m not sure how many banks got dropped.

The first thing I look at each trading day is which direction these four market indexes are moving. Many times they go up and down in unison. Other times, as an example, the Nasdaq may skyrocket higher due to tech stock focus, while the Russell (small caps) are dropping. This helps me gauge how the markets are trending.

There is overlap between these four indexes, because some of the same companies are included in more than one index. For example, Apple (ticker: AAPL) is a component of both the S&P (broader market) and the Nasdaq (high number of tech stocks). But AAPL is not included in the Russell (smaller companies). Thus, the S&P and Nasdaq have a stronger correlation between each other than against the Russell.

The screenshot below shows the correlation between:

SPY = S&P500; IWM=Russell; QQQ=Nasdaq; DIA=Dow

Looking at the first column, notice that SPY is the header. Looking down to the second row – column 1 – IWM has a 38% negative correlation to SPY. The third row – column 1 – QQQ has a 96% positive correlation to SPY. While the fourth row – column 1 – DIA has a negative 36% percent correlation to SPY. That means that generally (but not always), SPY and QQQ will move in similar directions; and IWM and DIA generally move independently of SPY and QQQ.

(above chart per MicroAxis.com)

Economic scenarios can affect various stock sectors differently. For example, I have noticed that changes in interest rates have a different impact on QQQ (Nasdaq-Tech heavy) versus IWM (Russell – Banks). Interest rates are currently low. In today’s interest rate environment, you can borrow money (i.e., auto loan, mortgage) at a very low rate. And, if you deposit money in a savings account, the interest you earn will also be very low. Banks make more money when there is a wider gap between the interest rate banks make off of your loans versus the interest rate the bank has to pay you each month for keeping your savings account funds with them. Banks have not been making enough net revenue on this spread in recent times. However, the outlook for banks going forward is favorable, because at some point interest rates will increase, producing a bigger net income spread.

Tech stocks are impacted by interest rates in reverse of banks. When interest rates are low, Tech stocks can purchase more materials at lower prices. But when interest rates eventually go back up, Tech stocks will have to pay more.

To summarize, following broad market trends can help in formulating opinions and trade ideas. Overarching trends can last a long time, such as straight up during this current multi-year bull market. But underneath the main trend, we can uncover money flows in and out of different sectors and industries that also help in assessing our next moves.

Notes: (www.investopedia.com was used to formulate index definitions)