So we’ve gone through many of the specific terms and descriptors about an individual stock … so now we’re moving on to describe measures of the total stock market (Oh boy, oh boy sounds fun! Hang in there and keep learning … you could wind up a millionaire one day because you did.)
The popular press quotes several indices which measure the broad movement of the prices of stocks. Remember, these indices do not reflect the returns received by stock investors in the forms of dividends … they only account for the changes in prices of the underlying stocks within the index. Three of these indices are frequently used, but there are literally hundreds of others that track movement in a specific type of company or that look at international stocks. Here are the main three you should know:
Dow Jones Industrial Average (DJIA):
This is probably the most popular measure of stock prices, but not the best. This measure follows 30 of the largest companies in the U.S., and its movement is based on how each of the underlying 30 stocks did during that day. It is known as a “price-weighted” index – where the companies with the largest share price have the biggest impact on the index. This is misleading since it doesn’t track the true value of the stocks (known as market capitalization = share price x shares outstanding) but rather is based only on the price of the stock. (Whoop that knowledge out at happy hour and impress some friends!!!)
The NASDAQ is primarily known as the main stock exchange (alongside the New York Stock Exchange), but they also issue an index that shows the movement of the 3,000+ stocks that trade on the NASDAQ exchange. This is a value-weighted index – so the companies that are worth the most (high market cap) and their respective price movement have the most impact on the index. Due to the high number of technology and smaller firms that trade on the NASDAQ, this index is generally seen as a barometer for the price movement in growth and technology companies.
Standard and Poors 500 (S&P 500):
The S&P 500 is a much better measure of total stock market movement since it includes about 500 of the largest companies in the U.S. (compared to 30 for the DJIA), is a value-weighted index (so it tracks the true market value of companies and not their stock prices), and it covers all sectors of the economy (unlike the technology-heavy NASDAQ). The roughly 500 companies that are in this index are collectively worth over $25 trillion (as of April 2020), or roughly 80% of all the value of public stocks in the U.S.
Within the S&P 500 are 11 general categories of the economy under which every company falls. By looking at each sector’s weight in the S&P 500 index we can get a sense of what type of companies drive the U.S. economy. The companies you own shares of stock in should resemble these proportions since you want to be diversified across all sectors of the economy. That way if one type of industry performs poorly (but others perform well) then your stocks won’t be focused on the losing sector.
- Information Technology (25.7%): Being the largest component of the S&P 500 index shows how powerful a part technology firms has become in our economy. But in the early 1990’s this sector had only about a 5% weighting on the index! During the technology bubble days of 1999-2000 this sector reached upwards of 30% of the index when technology firms were priced very unreasonably at the onset of the internet era. Companies in this sector range from software makers, hardware manufacturers, internet services firms, semiconductor makers, data storage firms, and many other technology service firms. These firms have seen remarkable growth in a relatively short time, and will likely continue to do so due to the continued improvements in technology.
- Health Care (15.4%): Health care continues to be a sector of major importance to this index (and thus also our economy). The uncertainty of health care legislation and further reforms will likely persist, but these firms will continue to benefit from a growing population of old-folks in our country and around the world. Drug companies continue to invest in research and development of new medicines to replace their drugs that may be losing patent protection in the years ahead.
Companies in this sector range from drug researchers and manufacturers, medical device makers, biotechnology firms, health insurers, and hospital operators.
- Communications Services (10.8%): The Communications Services sector is new to the S&P 500 as of September 2018. This sector reshuffled businesses to now include mature telecommunications businesses, consumer media companies, and internet companies. This adjustment to the index lowered the weighting to the Information Technology and Consumer Discretionary sectors and is now a unique combination of businesses that were previously spread across different sectors.
- Financial Services (10.6%): Before the financial collapse this sector held a dominant lead over the IT sector as the largest in the index at well over 20% (perhaps a sign that things were getting a little out of control), but the struggles of many of these firms and the resulting drop in their share prices and market values dropped them to the #4 spot. Financial firms continue to adjust their businesses following the powerful recession in 2007-2009 and the resulting legislation and regulations issued thereafter.
- Consumer Discretionary (10.5%): This sector feeds off of one of America’s greatest strengths – our ability to buy crap we don’t need. Discretionary items contrast to staple items in that they are our purchases of items that we don’t need on a daily basis but that we like to have. This sector is also extremely mature and competitive and includes auto-makers, retailers and restaurants. Companies in this sector are more susceptible to swings in the economy since when Americans lose their jobs or their income’s fall then they will likely forgo their $5 daily latte at Starbucks before they discontinue their staple purchases like milk and toilet paper.
- Industrials (7.9%): This sector may be easiest described by those firms that make heavy equipment, their suppliers, and the firms that move these goods. Examples would include defense companies, construction equipment makers, engine makers, residential homemakers, and shipping and railroad companies. The industrial and manufacturing sector has been on a steady decline in terms of overall importance to our economy over the past 30+ years with advances in technology and outsourcing, but the share of manufacturing’s importance to the U.S. economy has grown coming out of the 2008 recession as it has become relatively cheaper to make products in the U.S. instead of overseas.
- Consumer Staples (7.4%): The role of consumer spending by Americans constitutes a huge role of total U.S. economic output – over 70% of total US economic activity is based on just Americans spending money on the stuff we consume and the services we use. The consumer staples sector is comprised of the companies that make and sell the staples of our lives, or the everyday products like packaged foods, household cleaning supplies, textiles, and the companies that distribute and sell these items (think of most of the stuff in Wal-Mart). This industry is considered “mature” since it is slower growing and there is much competition amongst firms. These firms have historically had more stable stock prices due to their strong and established businesses and large and stable dividend payments. Successful firms will be able to grow their sales by expanding internationally and into emerging markets where groups of people are just beginning to buy and use the goods we fat Americans have used for generations.
- Utilities (3.3%): Companies that produce and distribute power comprise a small amount of the S&P 500 and are generally sought after by investors looking for a high dividend payment. Many utilities offer yields of over 5% since they do not offer promising long-term growth opportunities. Demand for power by big industrial consumers can fall during a recession, but with new sources of low-cost natural gas, these companies are able to produce power at a lower cost. These companies normally need political approval to raise prices which is very unfavorable for investors. Potential limits on carbon and other pollutants could impact these companies (like EPA rulings on coal-burning power plants) which will require them to source more energy from more expensive renewable sources.
- Energy (3.0%): China recently passed the U.S. in terms of how much energy each country consumes after our country’s 100+ year place in front (but on a per-person basis we win as the most inefficient peoples of the world by a long shot). This sector includes the firms that explore, drill, refine, and distribute primarily oil, natural gas, and coal to feed the energy needs of ourselves and growing foreign economies. Improved technology has allowed these firms to more efficiently drill for oil at lower costs, drill more oil out of existing wells, and find new reserves in areas previously unreachable by drills. The declining energy prices helped push down prices of these companies and dropped their weighting in the S&P 500 down to 8th place in 2020 from 4th place in 2014.
- Real Estate (2.9%): The real estate sector and the related companies were previously categorized as financial companies until they were spun off into their own S&P 500 sector in 2016. The majority of companies in this sector are classified as Real Estate Investment Trusts (REITS) which are companies that own and operate real estate of many different types ranging from office buildings to warehouses to shopping malls etc.
- Materials (2.5%): This sector includes a wide variety of commodity-related businesses including chemical makers, miners of various metals and minerals, steel producers, and agriculture fertilizer and chemical companies. We previously mentioned that if you want exposure to commodities (whose prices rarely grow faster than the general rate of inflation) then over long time frames you will likely be better served by investing in companies involved with mining and selling those goods instead of the goods themselves. Companies that mine only a few commodities can be subject to volatility in the prices of the commodities they mine which makes share prices volatile as well.