What is the Market?

You may have heard someone ask, "How's the market doing today?" Most of us recognize that people are generally talking about the stock market. However, actually breaking down the stock market isn't quite that transparent. Here we will cover what people generally mean by "the market" and go over why that's the case.

A Broad Overview

The broadest interpretation of the phrase can be seen as the stock market in general. Each and every stock comprises the equity market, but it's not very transparent how one would be able to look at every stock at the same time. To get a better sense of the overall picture, market indexes were developed. These indexes attempt to tie the entire stock market to a single instrument and eliminate the rigor of getting a holistic view of all the stocks. The Dow Jones Industrial Average was among the first to solve this problem.

The Dow

The most well-known early stock market index was the Dow Jones Industrial Average, or the Dow for short. The index still exists and was a revolutionary idea for its time. The creators took 30 prominent stocks and averaged them. Insanely complex. While it seems relatively simplistic, it was a great way to see how companies were performing for its time. However, problems quickly arose, like accounting for stock splits, issuing new shares of stock, and how representative of the entire stock market this actually was. Long story short, not very. This eventually gave rise to the market capitalization-weighted index.

The S&P 500

A market capitalization-weighted index, or market cap for short, is a much better estimate of what the entire stock market actually represents. Market capitalization is simply how much the entire company's stock is worth: stock price multiplied by the number of shares. When people refer to "the market" now, they are usually referring to a market cap index and more specifically the S&P 500. Instead of weighting stocks by the price, like the Dow, it weights them by the company value. It also takes into account a much larger number of individual stocks, in this case, 500 instead of 30, and uses the 500 largest companies.

This is a much better representation of the overall stock market. The largest 500 companies are a huge chunk of the overall value of equity markets (although still not perfect). It also has a much more accurate representation of the actual value by using the overall company value instead of just the price.

Wrapping up

While it is still an imperfect tool, the S&P 500 is usually what people are talking about when they say "the market." It is a reasonable depiction of how the stock market is doing overall but is still only a representation. There are actually several other more recent indexes that cover more companies and would arguably be a better overall representation, like the Wilshire 5000. However, when people refer to "the market," they're usually talking about the S&P 500.