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  • Writer's pictureEmily Dow

2020 - a year to remember (stock market style)

Stock exchanges and stock indices are two different things, yet I've heard people compare NYSE and S&P 500 as if they are two of a kind. Both play important roles within the economy, in fact what happens on a stock exchange can dictate the results of a stock index.

To start us off, what is a stock exchange? This is the centralised location where shares of publicly traded companies are traded (bought and sold). These 'locations' can be physical, such as the NYSE, or virtual such as the NASDAQ. The NYSE is the largest stock exchange in the world, and the NASDAQ, along with the LSE and the TSE are the largest three following (combined are less than the NYSE, however). You may have heard of an IPO, which stands for Initial Public Offering. This is the initial price a firm sells their shares for during the process transitioning from a private to a public firm. After the issuer presents this price to public investors, their shares are then traded on the open market. For a firm to feature on a stock exchange they must pay all fees (entrant and annual), as well as often meet certain requirements, such as but not exclusive to: number of shareholders, minimum shareholder's equity, minimum share price.

Now onto the next, what is a stock index? This measures what happens in the stock market/exchange. It enables investors to judge current overall share prices, compare these to past prices, and create an overall image of stock market performance. Indices are not only used in the stock market, they are used to indicate other economic conditions too. The Consumer Price Index (CPI) uses a 'basket' of goods weighted in accordance to importance and personal spending (for example, bread is a common everyday item purchased by individuals - there are over 180 000 goods recorded on this index!) to monitor the change in overall prices across the country - inflation. Just as CPI does not monitor all goods in the country, so too does a stock index. Each index follows and weights a different combination of firms from different industries, therefore reflects a different image of market conditions. The three most observed US stock indices are the Dow Jones Industrial Average, S&P 500, and NASDAQ Composite and all variations of the FTSE (Financial Times Stock Exchange Group) follow companies listed on the LSE for the UK. Indices link to the trading strategy indexing, a method of passive management, where investors (or often investment managers) ensure trades follow the general trend and movements of the overall market (thereby following a stock index) and match the given risk and return of the overall market, rather than trying to outperform the market (know as active management).

After a global downturn such as a pandemic, all stock indices would be expected to decline due to the overriding impact of depressed demand. This was initially the case. March 9th, 12th, and 16th 2020 were the three largest point drops in US stock market history for the Dow. However, it managed to rally and still end the year positively as shown below:

On top of this, S&P 500 gained 16%, the NASDAQ Composite gained a large 40+%. China's CSI 300 index managed to gain an impressive 27%, Japan's Nikkei rose 16% and Germany's Dax finished positively too. Yet FTSE, and therefore the UK stock market finished 14% weaker than the beginning of the year. These results highlight the importance and impact that the content of stock indices can have on the reflection of a country's economic performance. The heavy technological weighting of the NASDAQ Composite is the core cause of their results, and therefore it's no surprise to see it performing so well in a year where the world has depended upon technological advances for communication and survival. The strong weighting of one industry may have served the NASDAQ Composite well, but it did not for FTSE. The latter has a heavy energy, oil, and natural resource weighting, all hard hit by the pandemic. In fact, demand for oil suffered so much that the price per barrel of Brent oil dropped to negative figures for the first time in history in April 2020 (shown below):

The imbalance of global recovery experienced by different industries is a perfect example of how different stock indices convey different accounts of market conditions, and how this in turn impacts national comparisons. Additionally, it provides good indicators to investors with regard to what industries are performing well in general, rather than specific businesses (the purpose of a stock index).

It should be noted that the businesses included in stock indices aren't static, in fact, they are very fluid as they need to be reactive to fast growing businesses. Tesla joined the S&P 500 on December 21 2020, being the company of greatest value as well as the largest weighting added ever. Differentiating between a stock exchange and a stock index for the last time, an index is a selected number of firms used to represent a section of the market, therefore when Tesla was added, they replaced Apartment Investment and Management Co., a real-estate company. This reflects the indices adjusting to reflect a current image of the markets.

Sources used:

UK stocks wrap up worst year since 2008 while US and China rebound

Google Finance Market Summary

Dow Jones Industrial Average

The Top Performing Stocks of 2020

Tesla Stock Is Now Part of the S&P 500 - and the Index Will Never Be the Same

Tesla to Replace Real-Estate Stock in S&P 500

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