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Stock indices

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America has the S&P 500 Index. Japan has the Nikkei 225 Index. Australia has the ASX 200. The UK has the FTSE 100. And Germany has the DAX 30 Index. Stock exchanges around the world calculate and publish a range of indices to track the performance of a specific “basket” of stocks traded on their stock exchanges.

A stock index is a measurement of the value of a section of the stock market, not the entire market. A group of similar stocks are grouped together to form an index. This classification may be based on industry lines, company size, market capitalisation or some other basis. There are indices for almost every sector of the economy and stock market. 

At the end of each day’s trading, news reports tell us whether the market fell or rose. But that does not mean that every single stock moved in unison. The term “market” means an index. On any given day, individual stocks can and do move in the opposite direction to the market index as the market is not a single entity. 

National indices are composed of the stocks of companies listed on a country’s stock exchanges. The Dow Jones Industrial Average is arguably the world’s best known and most widely followed stock market index. It consists of 30 large, publicly traded “blue chip” firms in the US and includes financial services companies, computer companies and retail companies. 

Around the world, broad market indices - like the Hang Seng Index - attract the most media coverage. But there is a host of more narrow indices that measure the performance of different groups of shares. The NYSE Arca Tech 100 is a specialised index for US technology-related stocks while the ASX Small Ordinaries Index is a key benchmark for small-cap investment in Australia.

Market indices record the ups and downs of investing and function as statistical gauges of the market’s activities. Investors use indices to track the performance of the broader market or a discrete segment. Indices reflect the sentiments of investors and the direction of the market. In share-market parlance (as explained by Investopedia) there are two types of markets - bull and bear.

The use of “bull” and “bear” to describe markets comes from the way the animals attack their opponents. A bull thrusts its horns up into the air, while a bear swipes its paws downward. These actions are metaphors for the movement of a market. If the trend is up, it’s a bull market. If the trend is down, it’s a bear market.

Bull markets are characterised by optimism, investor confidence and expectations that strong results should continue. In contrast, bear markets are characterised by falling prices and are typically shrouded in pessimism. Bull and bear markets typically coincide with the economic cycle. To again quote Investopedia

The onset of a bull market is often a leading indicator of economic expansion. Because public sentiment about future economic conditions drives stock prices, the market frequently rises even before broader economic measures, such as GDP growth, begin to tick up. Likewise, bear markets usually set in before economic contraction takes hold. A look back (at most recessions) reveals a falling stock market several months ahead of GDP decline.

Investor sentiment is reflected in performance indices because the market is determined by the attitude of investors. Indeed, stock market performance and investor psychology are mutually dependent. We have long known that investors are not unemotional. Thus the old Wall Street saying that the market is driven by just two emotions: fear and greed

The Global Financial Crisis (GFC) revealed the devastating impact that human emotions have on markets. During the GFC, investor confidence plummeted causing a stampede for the exit door. The human species was convinced it faced financial Armageddon and this supposedly intelligent herd animal behaved like one of Pavlov’s dogs - the market rings the bell and hysteria starts.

The GFC equity market panic demonstrated that markets are not populated by rational decision makers. One can only wonder - if we had acted more rationally - whether we could have avoided or mitigated the market death spiral. Ironically, the panic sell-off was partly fuelled by market indices which became self-fulfilling prophecies that put markets in a steep slide.

Indices are the pulse of equity markets but they are not perfect. They provide snapshots of market movements but not always the full picture. In reality, stock prices are governed by expectations which may or may not be rational. If an index is down, many investors will automatically adopt a bearish outlook. In contrast, if an index is up, sentiments will invariably turn bullish. 

We find it easy to rely on indices and the 30-second trend analysis that they provide. While index sound-bites are certainly helpful, they should never replace sound reasoning. Sometimes it’s best to ignore the herd and stay the course.


Paul J. Thomas, CEO


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CEO Paul Thomas