U.S. Stock Market

A description of the U.S. stock market including various stock market indices, earnings, and dividends using a number of relevant new charts.

First, a definition of some terms might be helpful:

• share of stock in a company - a share of ownership in that company

• stock - the shares sold by a particular company

• stock exchange - place (real or virtual) where stocks of companies are traded (bought and sold)

The U.S. stock market, then, is everything associated with buying and selling of shares stocks in U.S. stock exchanges. The characteristic of a stock that is most referenced is price. A stock's quoted price is the amount of money paid for the most recent share of that stock to be traded on a stock exchange. Whenever stocks are being traded, quoted stock prices rise and fall based on the prices for which stocks are actually bought and sold. It is often valuable to be able to track the prices of a group of stocks instead of just an individual stock. A number of stock market indices have been created to do just that. These stock market indices are calculated from various groups of stocks using various formulas.

The most widely known and followed U.S. stock market index is the Dow Jones Industrial Average (DJIA). The DJIA is calculated from the price of just 30 stocks. The following chart shows monthly value of the DJIA going back more than a century:

The DJIA is denominated in U.S. dollars, and due to inflation, the value of these dollars change over time. Therefore, a better representation of the change in value of the DJIA over time would be one that is adjusted for inflation. The following chart is adjusted for consumer price inflation:

Another widely followed U.S. stock market index is the NASDAQ Composite (aka the NASDAQ). The NASDAQ Composite index was created much more recently than the DJIA, and it is known for containing a large number of technology stocks. The following two charts show the monthly NASDAQ and real (inflation adjusted) NASDAQ values over time:

The S&P 500 index is composed of the stocks of the 500 most valuable companies traded in the U.S. Because of this, the S&P 500 is a much better measure of overall U.S. stock market performance than DJIA or the NASDAQ. Also, the value of the S&P 500 can be calculated back in history for a significant period of time before it was even created. The next two charts show the monthly value of the S&P 500 and real (inflation adjusted) S&P 500 going back more than a century.

A share of stock has value because it represents a share of ownership in the assets and future earnings of a company. The next chart shows the earnings yield for the entire S&P 500 index. The earnings yield is annual earnings as a percent of stock price. One way to think of earnings yield is the annual percent return on investment a shareholder would get if all earnings were given to shareholders.

Of course, if all of the earnings were given to shareholders, the company would not have any money to invest in future growth, which could reduce future earnings. Therefore, companies do not typically give all earnings to the shareholders.

There are two primary mechanisms through which some of the value represented by company earnings can be transferred to shareholders. First, the perceived value of a share of stock, that is the price, could go up after purchase of the stock enabling the holder of the share to sell it at a higher price. Second, the company could decide to distribute some money to shareholders. Such a distribution of money is called a dividend. The next chart shows the dividend yield for the entire S&P 500 index. The dividend yield is the dividend paid out over the previous year as a percent of stock price. The dividend yield is the actual annual percent return on investment for a shareholder ignoring changes in stock prices.

Dividends can only be paid out from current and past retained earnings. The next chart shows S&P 500 earnings and dividend yields on the same chart, and demonstrates that dividend yields are typically lower than earnings yields.

The next chart shows dividend payout ratio, that is the percent of earnings that are paid out as dividends.

If one were to hold a stock for the entire lifetime of a company, all of the value of this stock would come from dividends. While most people buy stocks with the intent of eventually re-selling them at a (hopefully) higher price, it is good to keep in mind that the long term value of a stock is determined by the stream of dividends it provides.