The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

STOCK MARKET INDICATORS

Stock market indicators have come to perform a variety of functions, from serving as benchmarks for evaluating the performance of professional money managers to answering the question “How did the market do today?” In general, market indexes rise and fall in fairly similar patterns. Although the correlations among indexes are high, the indexes do not move in concert at all times. The differences in movement reflect the different manner in which the indexes are constructed. Three factors enter into that construction: the universe of stocks represented by the sample underlying the index, the relative weights assigned to the stocks included in the index, and the method of averaging across all the stocks.

The stocks included in a stock market index must be combined in certain proportions (i.e., each stock must be given a weight). The three main approaches to weighting are: (1) weighting by the market capitalization, which is the number of shares times price per share; (2) weighting by the price of the stock; and (3) equal weighting for each stock, regardless of its price or its firm’s market value. With the exception of the Dow Jones industrial averages (such as the DJIA) and the Value Line Composite Index, nearly all of the most widely used indexes are market-value weighted. The DJIA is a price-weighted average, and the Value Line Composite Index is an equal-weighted index.

Stock market indicators can be classified into three groups: (1) Those produced ...