WHAT IS A STOCK MARKET INDEX?
W’hen stock market observers discuss the state of the market, they usually talk in terms of an index or several indices. In Malaysia, the most commonly used indices are the NST Industrial Index and the KLSE Industrial Index and in Singapore, the most quoted is probably the Straits Times Industrial Index even though in recent years the various SES indices have become increasingly popular. What is an index and what are the uses of indices?
A stock market index is a measure of the average price level of the shares traded in the market. Its use is analogous to the use of degree Celsius to measure the temperature. It is constructed by comparing the current price of a sample of shares with their prices at some earlier date. Stock market indices are usually constructed by newspapers or the stock exchange itself as a service to the public so that it is informed of the current price level.
The organisation which is setting up the index (e.g. the KLSE) has to make two decisions regarding the design of the index. First, what are the companies to be included in the index? Second, what is to be the starting point of the index? Both the decisions would involve a certain degree of compromise. The more companies that are included in the index, the more accurate is the index in representing the actual situation at the stock market However, the more companies there are the slower is the computation, unless the exchange is fully computerized. In general, 30 companies is a good compromise. This is “M number chosen for the ST as well as KLSE Industrial Index.
The second decision is related to the starting point of the index. Th}, is usually restricted by the age of the stock exchange as well as tin amount of funds available for research going back into the past. The further back an index goes, the more expensive it is to set it up. For example, KLSE Indices have the starting date of 1st January 1970. Although an index can be given any arbitrary value as its base value, it is usual nowadays to use 100 as the base value. Thus the KLSE Indices are given the base value of 100 as at 1st January 1970.
There are various ways of computing an index but the easiest way to understand is probably the one using the market value of the companies included in the index. This can be seen by using an example with only two companies in the index. Assume that there are two companies “A” and “B”. Company A has 10 million shares and company B, 50 million shares. Their respective price and market value (i.e. the number of shares multiplied by the market price per share) at 1st January,
1970, (the starting point of the index) and at 1st July 1983 are given in Table below:
Company No of Shares (1st Jan 1970 ) (1st July 1983)
Com.A 10 M $1.00 $ 10 M $2.00 $ 20 M
Com.B 50 M $3.00 $ 150 M $4.50 $ 225 M
Total Value of Index Companies: $160 M $245 M Percentage Change in Total Market Value: + 53.1%
We can see from the above that the total market value of the companies selected for the index has increased by 53.1 per cent between 1st of January 1970 and 1st of July 1983. However, it is inconvenient to talk in terms of actual market values or in terms of percentage increase, Therefore, the current market level is always expressed as a ratio of its value at the starting date. The current value of the index is its starting value multiplied by the percentage change. In the example used, the index would stand at 100 at 1st of January 1970 and 153 at 1st of July 1983. The KLSE Industrial Index, which has a base value of 100, stands at 700 at the time of writing (end of August 1988). This means that the market value of the companies chosen for the index had increased their total value by 600 per cent since 1970 (an average annual increase of 11.5 per cent). This is a fantastic achievement by any normal standard. It is worthwhile to remember how indices are calculated and remind ourselves how much the market has gone up in the next bull run. When the market is next in a manic phase, we have to ask ourselves if it is feasible for the market to continue its performance in the future.