What is an Index?
Stockscores.com Perspectives for the week ending March 7, 2008
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In this week's issue:
This past week, one of our readers asked me what exactly a stock market index is and what they represent. The more important question is how investors should use indexes to make money in the stock market.
For a description of what a stock market index is, I went to Wikipedia, the online encyclopedia. Here is what they have:
A stock market index is a listing of stock and a statistic reflecting the composite value of its components. It is used as a tool to represent the characteristics of its component stocks, all of which bear some commonality such as trading on the same stock market exchange, belonging to the same industry, or having similar market capitalizations. Many indices compiled by news or financial services firms are used to benchmark the performance of portfolios such as mutual funds.
Types of Indices
Stock market indexes may be classed in many ways. A broad-base index represents the performance of a whole stock market - and by proxy, reflects investor sentiment on the state of the economy. The most regularly quoted market indexes are broad-base indexes comprised of the stocks of large companies listed on a nation's largest stock exchanges, such as the American Dow Jones Industrial Average and S&P 500 Index, the British FTSE 100, the French CAC 40, the German DAX, the Japanese Nikkei 225, the Indian Sensex and the Hong Kong Hang Seng Index.
The concept may be extended well beyond an exchange. The Dow Jones Wilshire 5000 Total Stock Market Index, as its name implies, represents the stocks of nearly every publicly traded company in the United States, including all U.S. stocks traded on the New York Stock Exchange (but not ADRs) and most traded on the NASDAQ and American Stock Exchange. Russell Investment Group added to the family of indexes by launching the Russell Global Index.
More specialized indices exist tracking the performance of specific sectors of the market. The Morgan Stanley Biotech Index, for example, consists of 36 American firms in the biotechnology industry. Other indexes may track companies of a certain size, a certain type of management, or even more specialized criteria - one index published by Linux Weekly News tracks stocks of companies that sell products and services based on the Linux operating environment.
The article continues on with more detail of what indexes are, you can read it by clicking here
What I want to focus on is how investors can use indexes to make decisions in the market.
To begin, investors first need to understand the concepts of Alpha and Beta. There are two factors that affect where a stock will go. Those relating to the company and its specific business are the Alpha factors and those relating to the general economy or industry are the Beta factors. These names are derived from the statistical concept of linear regression where the Beta is the correlation of the stock to the overall market or industry group and the Alpha is the part of the stock's performance which is independent of the market.
As a general rule, the larger the market capitalization of a stock (how much the company is worth) the more it will correlate with the overall market. So, large cap stocks are considered Beta stocks because they tend to perform in similar fashion to a broad market index. If you plot General Electric (GE) and the Dow Jones Industrial Average (DIA) on the same chart you will find that they look very similar.
So, if you are interested in investing in large cap stocks, a big part of your analysis should be a consideration of a broad market index. It will also be helpful to look at a chart of the stock's industry group to see where that is likely to go. For example, GE falls in the Diversified Industrials Index (.DJUSID). When you look at the Stockscores Quick reports, one of the information tabs is labeled Sector; you can find the chart of the industry group there.
If the market index is not performing well, then you want to avoid stocks that have a strong correlation to the market (or short them). In this case, you want to seek Alpha stocks, those that are trading on their own story and better able to move up despite general market weakness. This will tend to be lower capitalized stocks or companies that have the potential for very significant fundamental change despite the market's weakness.
So, we look at market indexes to help us determine where individual stocks will go because stocks have a correlation to the overall market or industry group. If the index performance does not fit with our investment goals then we will have to look to trade stocks that are not heavily correlated to the overall market.
In recent years, the market has seen a new class of investments become popular. Exchange Traded Funds (ETFs) are basically tradable indexes. They are baskets of stocks compiled under one symbol that can be bought, sold and shorted just like a stock. They are a way to trade an index.
The main benefit of this is that an investor can trade a diversified basket of stocks with just one transaction, taking away much of the risk inherent in buying single stocks. The most popular ETFs include the Dow Diamonds (DIA), Nasdaq Powershares (QQQQ) and the TSX 60 iShares (T.XIU). There are many more, I recently wrote a newsletter on ETFs which can be found here.
Indexes have become a very important part of investing. They help us determine where the stock market and sectors of it are likely to go in the future and they can now be traded using ETFs. All investors should include some top down analysis of the indexes in their research process.Back To Top
The markets continued to get beat lower this week and the Nasdaq broke down through some pretty important support. While we may get a short term bounce back, I think any show of strength is probably a bull trap and this market is more likely to go lower than higher in the next little while. With that in mind, I ran the Long Term Breakdowns strategy on the Nasdaq market to look for some short sell set ups. This strategy looks for stocks breaking long term support and the idea is to short sell these stocks for the ride lower.Back To Top
1. MGAM
MGAM broke down through support at $7 this week out of a pattern that has falling tops, indicating the sellers are in control. Resistance at $7.80 should be the stop loss point.
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2. IVGN
Long term upward trend line was broken about six week ago and now the stock is consolidating downward as the sellers gather momentum. Broke through some support this week, I think it can go to $70 from here. Put resistance around $88.
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References
Get the Stockscore on any of over 20,000 North American stocks.
Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
Scan the market using extensive filter criteria.
Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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