Stock Market Index Explained

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Purpose and Limitations of Stock Market Index

What does the Stock Market Index mean? Stock Index futures offer the investor a medium for expressing an opinion on the general course of the market. The general movement of the stock market is usually measured by averages or indices consisting of groups of securities that are supposed to represent the entire stock market or its particular segments. Thus, Security Market Indices or Security Market Indicators provide a summary measure of the behavior of security prices and the stock market. So, what is the topic we are going to discuss: Purpose and Limitations of Stock Market Index!

Explained Stock Market Index Concept with their Purpose and Limitations!

Introduction to Contents:

The principal stock market indices used in India are the Bombay Stock Exchange Sensitive Index (BSE Sensex) and the S&P CNX Nifty known as the NSE Nifty (National Stock Exchange Fifty). In addition, these contracts can be used by portfolio managers in a variety of ways to alter the risk-return distribution of their stock portfolios. For instance, much of a sudden upward surge in the market could be missed by the institutional investor due to the time it takes to get money into the stock market.

Stock Index Futures:

By purchasing stock- index contracts, the institutional investors can enter the market immediately and then gradually unwind the long futures position as they are able to get more funds invested the stock. Conversely, after a run-up in the value of the stock portfolio (assuming it is well diversified and correlates well with one of the major indexes) a portfolio manager might desire to lock in the profits much after being required to report this quarterly return on the portfolio.

By selling an appropriate number of stock index futures contracts, the institutional investors could offset any losses on the stock portfolio with corresponding gains on future position. As a speculation tool, stock index futures represent an inexpensive and highly liquid short-run alternative to speculating on the stock market.

Instead of purchasing the stock that makes up an index or proxy portfolio, a bullish (bearish) speculation can take a long (short) position in an index futures contract, then purchase treasury securities to satisfy the major requirements. A long or short speculative futures position is referred to as a purely speculative position or a naked (outright) position.

The Purpose of an Index in the Stock Market:

The security market indices are indicators of different things and are useful for different purposes.

The following are the important uses of a stock market index:

  • Security market indices are the basic tools to help and analyze the movements of prices of various stocks listed on stock exchanges and are useful indicators of a country’s economic health.
  • Indices can be calculated industry-wise to know their tread pattern and also for comparative purposes across the industries and with the market indices.
  • The growth in the secondary market can be measured through the movement of indices.
  • The stock market index can be used to compare a given share price behavior with past movements.
  • Generally, stock market indices are designed to serve as indicators of broad movements in the securities market and as sensitive barometers of the changes in trading patterns in the stock market.
  • The investors can make their investment decisions accordingly by estimating the realized rate of return on the stock market index between two dates.
  • Funds can be allocated more rationally between stocks with knowledge of the relationship of prices of individual stocks with the movements in the market.
  • The return on the stock market index, which is known as the market return, is helpful in evaluating the portfolio risk-return analysis. According to modern portfolio theory’s capital asset pricing model, the return on a stock depends on whether the stock’s price follows prices in the market as a whole; the more closely the stock follows the market, the greater will be its expected return.

Purpose and Limitations of Stock Market Index!

Limitations of Stock Market Index (Indices):

Though stock market indices are the basic tools to help and analyze the movements of the price of the stock markets and are a useful indicator of a country’s economic health, they have their own limitations also.

The following points deal with those limitations:

  • Whenever a company issues rights in the form of convertible debentures (to be converted at a later stage) or other instruments (warrants) entitling the holder to acquire one equity share of the company at a specified price at a notified future date, the equity capital increases only on conversion of debentures or the exercise of warrants/Secured Premium Notes (SPNs), option for equity shares but the market adjusts the ex-rights price of the share immediately (on the day the share starts trading ex-rights) on the basis of the anticipated increase in equity capital and likely reduced earnings per share, etc.
  • Hence, some modification is needed to adjust the equity capital suitably in advance. But the exact procedure by which this can be done is very difficult to state since the internal market mechanism which adjusts the ex-rights share price is almost impossible to know precisely.
  • Again, this is a common limitation of all the indices and so far, the increased equity capital is considered only after the debentures are converted into shares and are acquired for warrants/SPNs and the new shares are listed for trading on the stock exchange.
  • The coverage (in terms of number of scrips, number of stock exchanges used and the respective weights assigned) is different for all the indices and hence, each index may give only a partial picture of the movement of prices or the state of the market presented may be misleading.
  • The financial institutions sometimes convert the loans extended by them to companies into equity shares at a specified date. This causes sudden and significant changes in the market capitalization and hence the weights assigned to those scrips change violently.
  • The various stock market indicators around the world have been in use for many years and it has satisfied the needs of millions of investors and stockbrokers. But the stock markets, by their very nature, are very dynamic and hence, the indices should be revised or adjusted periodically to reflect the changed conditions so that they continue to be relevant.
  • Whenever prices of scripts listed on more than one stock exchange are used, most liquid prices (on anyone stock exchange) should be used (rather than the present practice of using the arithmetic average of prices on all the exchanges, as the same script may not enjoy the identical degree of liquidity on all exchanges).

The limitations indicated may not be eliminated totally, but appropriate adjustments are certainly called for. The classification of industries into various groups for calculation of various industry indices is presently rather vague and presents problems in the case of diversified companies. Also learned, What does Welfare Economics mean? Measuring and Value decisions!

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This should be made uniform or the classification should be made in such a way that it reflects the major operations carried on by each company. Overall, one can say that the various stock market indicators devised have more or less served their purpose, despite their limitations but these can be made more effective and dynamic by introducing appropriate modifications 0£ the existing ones to serve the investing public better.

Stock market explained

The stock market is a place where traders buy and sell shares, government bonds and other assets. The stock market shows the price of shares and facilitates companies to raise revenue from issuing shares. Investors buy shares for both dividends and the prospect of capital gains. the US stock exchange based in NY (NYSE) has a market value of US $30.1 trillion as of February 2020.

How the stock market affects the global economy

Movements in share prices can have an impact on the global economy. Most famously the Wall Street Crash of 1929 was an important factor in precipitating bank closures and the great depression of the 1930s. Whilst this was the most dramatic example, movements in share prices can have an influence over the rest of the economy.

If the economy goes into recession or if there is a period of financial uncertainty then stock markets will generally fall reflecting the negative economic news.

In turn, a falling stock market can impact the economy in a negative way.

Falling share prices will:

  • Reduce consumer wealth for those who own shares. Therefore, they may spend less, leading to lower economic growth
  • Reduce the value of pension funds and reduce private pension income (if it is a prolonged fall in share prices) another factor that could cut consumer spending
  • Falling share prices make it more difficult for companies to raise finance on the stock markets, leading to lower private sector investment.
  • Falling share prices tend to reduce consumer confidence.

However in evaluation

  • Not everyone owns shares.
  • People who own shares tend to be rich and can ‘afford to lose money’ on the stock market. Therefore, their consumption levels will not be affected at all.
  • Stock market crashes don’t always affect levels of economic growth. e.g. the 1987 stock market crash didn’t reduce growth at all. (Partly because interest rates were cut sharply)

Leading stock market indexes like the FTSE-100 and Dow Jones are important in the sense that it gives an indication of the health of the biggest economies. Rising shares are a good sign, falling shares a bad sign, but in the short term, a lot of price movements can be due to speculation.

How Share Prices Affect Companies

Readers Question: A company issues stock and sells it in a primary market at a fixed price. In that case, do fluctuations in the stock market affect specific companies? In other words, when the stock value of company crashes, is that company affected at all?

If the company sells 10,000 shares at £1, then it receives £10,000 which it can use for investment. If the share price then fluctuates, it doesn’t change the initial sum the firm gained. For example, if the share price fell to 60p, the firm would still have the initial investment of £10,000. However, if the share price collapsed it would affect the company in some ways:

  • It would be harder to issue a share rights issue to raise future capital (many banks are trying to do this at the moment)
  • The firm may become subject to a takeover, especially if the collapsing share price is due to bad management and other people think they can run the company better.
  • Also, it is worth bearing in mind that a collapsing share price is often a reflection of a badly performing firm – a firm which is making a loss. It is not the other way around ie. it is not that a fall in share prices will cause a firm to become unprofitable and inefficient.

The Role of the Stock Market for Investors

Readers Question: As well, how does the stock market affect the economy? I understand the purpose it serves in raising funds for companies but not the role it plays for the investors? Anything to do with saving?

The importance of the stock market includes:

1. Raising funds for companies

Barclays recently announced a share issue to raise just under $9billion. This is to try and help the company survive the credit crunch and so it is important for the banking system, which currently needs more liquidity.

2. A place for investment

Pension funds and investment trusts look for a variety of investment options. They will try to get a balanced portfolio to provide income and capital gains for their members. The stock market can traditionally offer a mix of interest (dividends) and capital growth over the longer term. Of course, the stock market is riskier, but, if investment trusts get it right they can offer an excellent return for their trust fund. People often forget how much dividends you can get from shares. For example, Barclays currently offer a dividend equal to 11% of the share value – making it excellent value (assuming they don’t have to write off billions of bad debt in the near future)

3. Share prices and affects on the economy

Movements in the stock market can also affect the macroeconomy in the long run through wealth and confidence effects.

Volatility of the stock market

“There is a saying: stock markets have predicted 10 out of the last 3 recessions.”

Readers Question: That does not make sense – how can you predict 10 out of 3? Did you not mean 3 out of 10?

The rationale behind the statement “stock markets have predicted 10 out of the last 3 recessions.” is that stock market volatility does not necessarily reflect economic conditions. If share prices fall 15% we may think that indicates a coming recession, but often share prices fall 15% – there is no recession, and then share prices recover.

Sometimes stock market investors panic; they think share prices are overvalued or some bad piece of economic news makes them fearful about future economic conditions. These small signals can, in some circumstances, can cause a rapid fall in share prices. The fall can then precipitate panic selling and share prices suddenly lose a large % of their value. However, later it is realised that the stock market has overreacted to a piece of bad news and actually conditions are not as dire as they feel.

Stock Market Crash of October 1987

On October 1987, stock markets around the world fell by about 25% in the space of a week. Many at the time felt this was due to an impending recession. However, economies continued to grow and the recession never materialised. Therefore, the stock market crash was not based on economic fundamentals, but, a chain of situations making people nervous and wanting to sell.

If a recession is coming, share prices will fall because a recession will mean lower profits and possibility of bankruptcy. However, just because share prices fall doesn’t mean the economy is going to do badly.

Also, I think the statement is a bit ‘tongue in cheek’ but, it is trying to emphasise the point that share price volatility is often divorced from economic reality.

Stock Index

What is Stock Index?

Stock index which is also known as the stock market index is a tool used to determine the performance of shares/securities in the market and to calculate the return on the stock of their investment and it is used by investors to have knowledge about the performance of investments and access the total value they possess.

Indexes are often used as a benchmark against which performances of Mutual Funds and ETF’s are compared. The stock index is further used as investment decisions before adjusting the portfolio. For e.g. a number of Mutual Funds compare their returns to the return in the S&P 500 displaying to the investors how their funds are performing in tandem with the stock index.

List of Top 5 Types of Stock Index

Below is the list of top stock indices –

#1 – Standard & Poor 500 (S&P 500)

S&P 500 is a large and diverse stock index made up of 500 of the most widely traded stocks especially in the USA. Since the USA is an epicenter of the financial activities impacting across the world, this index gives a good indication of movement in the US as a marketplace. The stock index is market-weighted (capitalization weighted), each stock is represented in proportion to its market capitalization. Thus, if the total market value of all 500 companies in the S&P 500 increases by 6%, the value of the index also increases by 6%.

Firms from various sectors are included in this index such as:

  • Financial sector
  • Healthcare
  • Industrials
  • Information Technology
  • Consumer Staples
  • Energy
  • Media

#2 – NASDAQ

It’s a stock market index of the US that measures the performance of around 3,000 companies including foreign companies. Predominantly, known for technology-based companies such as Google, Apple, and other firms in the growth stages, the NASDAQ also measures stocks from other sectors such as:

The value of NASDAQ is computed on the company’s outstanding stock i.e. market capitalization average of multiple firms part of the index. Therefore the performance of NASDAQ is directly proportional to the performance of the technology sector. There are 3 different market tiers namely:

  1. Capital market (Small-cap): An equity market for firms with small levels of market capitalization and requirements for listing is less stringent.
  2. Global Market (Midcap) includes around 1,500 stocks representing Nasdaq global markets and are required to meet strict financial and liquidity requirements. There are certain Corporate Governance Standards that have to be met.
  3. Global Stock Market (Large Cap) is a market capitalization-weighted index made up of US-based and international stocks. It is required to meet more stringent requirements as compared to the mid-cap and relatively exclusive in comparison to others. The listing department will regularly review the performance and associated rules governing these stocks.

#3 – DJIA (Dow-Jones Industrial Average)

The DJIA is one of the oldest and well-known indices in the world comprising 30 major companies belonging to the industry leaders which significantly contribute to the industry and stock market. The Dow is a price-weighted average stock market index indicating that any type of stock split or adjustment is not considered in the average price computation.

Since it represents a large section of the US market, a percent change in the Dow should not be interpreted as an equal chance in the overall market. This is due to the price-weighted function. For e.g., if the value of one stock falls from say $450 to $50, the entire stock market index may fall by around 3,000 points since the quantum of one stock weighs heavily on the base of 30 firms. As the index consists of some of the well-established companies in the US, large swings in the index can generally correspond to the entire market movement, though not necessarily on the same scale.

#4 – FTSE 100 Index (Financial Times Stock Exchange)

The stock index consists of 100 companies listed on the London Stock Exchange with the highest market capitalization which is maintained by the FTSE Group (the subsidiary of the London Stock Exchange Group). Many of these 100 firms are internationally focussed and hence may not be the best indicator of the UK economy is functioning and are significantly impacted by the exchange rate of the Pound. The FTSE 250 stock market index could be considered since it includes a smaller proportion of international firms.

The share prices are weighted by market capitalization so that larger firms make more difference to the index instead of the smaller ones. The basic Stock Index formula is:

The free float adjustment factor is the percentage of all issued shares readily available for trading. The free float capitalization of a company is calculated using the Market cap (number of shares * share price) and multiplied by the free-float factor. It does not include restricted stocks held by insiders such as ESOP’s.

#5 – Russell Indexes

Stock index is a family of global equity indices from FTSE Russell permitting investors which track the performances of specific market segments. Many mutual funds or ETF fund managers use FTSE Russell as benchmarks for measuring their respective performances. The most established index in the series is Russell 2,000 which exclusively tracks the US small-cap stocks of the Russell 3,000 stocks. The participants of the Russell 3,000 and its subsets are determined every year during the annual reconstitution with quarterly enhancements including any IPO’s. The top 1,000 companies are the large-cap ones and the others are the small-cap stocks.

The stock index has a rule-based and transparent process for forming the index by listing all firms in a descending order by market capitalization adjusted for the float (actual number of shares available for trading).

Final Thoughts

The stock index also referred to as the stock market index is an indicator of how securities of a section are performing. It’s a tool used by financial managers and investors for describing the market condition and compare the return on specific investments. The stock indexes are relatively easier to interpret and indicate live performance increasing their importance around the world.

The stock index has generally used a benchmark around the world to give a quick indication of how the stocks are performing across sectors. The movement also has a widespread impact on other macroeconomic factors such as Political and overall economy as well.

The stock index gives a quick indication of the direction in which the market is moving and also which industry/company is driving the change.

Stock Index Video

This has been a guide to what is a stock index? Here we discuss the top 5 stock market index including the S&P 500, NASDAQ, DJIA, FTSE 100 and Russel Indexes. You may learn more about stock markets from the following suggested articles –

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