Correlations Between Indexes

Since the Dow Theory was originally developed by Charles Dow at the end of the nineteenth century, it has become common to have various indices that measure the market as a whole.  Dow’s writing developed the idea that the prices of individual stocks move together and that it is possible to have a measurement that is a surrogate for the entire marketplace.  The Wall Street Journal developed the Dow Jones Industrial index with 12 industrial stocks in 1896 with a comparable railroad index.  Dow believed that when the railroad stocks were increasing, there would be a comparable increase in the fortunes of industrial companies.

In general, it appears to be true that each index does represent the value of the overall market.  Although today’s market indices are calculated in somewhat different ways, the various indices represent movements of the market as a whole.

There are differences among the various indices.

Risk is a factor that can make an index more or less volatile.  A risky stock, or an index of more risky issues, may follow the overall market movement but have more exaggerated price changes.  The NASDAQ, for example, includes more highly technical stocks that are vulnerable to significant failures or successes.  As a result, the NASDAQ will generally follow the movement of the DJI with a greater percentage move, both up and down.

Another difference between indices is the method of calculation.  The DJI is calculated by adding all of the prices of the 30 stocks in the average and dividing the total by a factor.  The factor is an historical number that is adjusted every time there is a change in the stocks included in the average.  As a result of this method, high priced stocks constitute a larger percentage of the index.  Changes in the higher priced stocks will result in larger changes in the index itself.  When AIG dropped in value precipitously it had a disproportionate impact on the value of the DJI.  Other indices are adjusted for that difference, relying only on percentage changes rather than absolute price changes.  The S&P 500 or the Wilshire 5000 both use a method that probably reflects the day-to-day changes better than the DJI.  Nonetheless, all of these indices tend to move in concert.

There are other very specific indices for unique investments.  Gold, for example, is commonly regarded as anti-cyclical, moving in the opposite direction of the overall market and going up when times are more chaotic and down when times are more serene.  To measure that market an index such as the HUI Gold Index measures the price of gold producing mining companies on the NYSE. There are other such indices for commodities or interest sensitive securities that can move opposite the overall market.

There is an underlying movement of the market wherein stock prices tend to move together, both up and down.  To the extent that an individual investor wants to participate in that market trend, there are special securities that allow the individual to invest in “the market”.  SPDR – Standard & Poors Depository Receipts – commonly known as SPIDERS and traded on the NYSE give the individual the ability to achieve a return equal to the entire market.  Changing in value every day in the same percentage as the S&P 500 this investment allows the investor to dismiss projections of individual securities and rely on the market’s overall movement.  An investor that foresees a strong market should consider the SPIDERs as a good strategy.

Market indices are a valid and proven assessment of the overall stock market.