Given enough time investing in the stock market, a trader will tell you that the research and analysis require the most time. In order to be successful, an investor needs to understand how the markets move and how to interpret differences in the various market indexes and what they mean. This kind of evaluation becomes an important part of an investor’s technical analysis of the stock market. It can add further clarity to various stock market movements and help an investor to find potential trades.
Let’s start this review by looking at each of the big three market indexes:
o S&P 500 – This market index is most commonly used by professionals in the financial world because it includes such a large sector of the market. It includes 500 of the most widely traded stocks and because it is a market cap weighted index, changes in larger companies tend to reflect more strongly than small cap stocks. The S&P 500 tends to be a more accurate indicator of market movements than the Dow.
o The NASDAQ Stock Market Composite – Even though this market index includes all of the stocks that are listed on the NASDAQ market, it is historically weighted toward technology stocks. This condition is the result of the fact that it is a market cap weighted index and thus the large cap stocks of technology companies strongly influence this index.
o The Dow Jones Industrial Average – This is the old-timer of the bunch. The Dow is the oldest, most widely known and most quoted of all the market indexes. The Dow tracks 30 of the most influential companies in the US and because it represents only large companies, it misses out on the small and mid-size companies completely. Unlike the S&P 500 and the NASDAQ, the Dow is a price weighted market index which means that if a stock price changes by $1, the effect on the market index is the same no matter the price of the stock. The Dow reflects only about 25% of the total market but changes in the Dow tend to reflect consumer confidence in the stock market as a whole.
What perspective does each index take?
Because each of the indexes takes a different approach, the stock market movement for each is different. For example, the NASDAQ structured so that technology stocks enjoy greater prominence that those in other stock sectors. This was evident in the late 1990’s when the technology boom was taking place. As events unfold that effect the technology sector, the NASDAQ will tend to see the most dramatic stock market movement, although the Dow will also be significantly affected.
The S&P 500, on the other hand, is not as severely impacted by tech stocks but tends to have a stock market movement that more accurately reflects the market in its entirety. Because it is weighted to the larger stocks it does not have the violent reaction to Wall Street news that its small-cap stocks might cause. The overall balance of the S&P 500 causes a more accurate representation of market movement than the Dow. This is the reason that most financial professionals use it as their barometer for stock market movement.
The Dow is the interesting one of the bunch; the granddaddy of the market indexes, it looks only to the 30 most influential stocks for its analysis of market movements. These are all large-cap stocks so they do not accurately evaluate the entire market, yet the Dow has proven to be the best market index for indicating consumer confidence.
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