Many investors judge the health of the UK stock market by monitoring a single index, generally the world-famous FTSE-100. It is a poor system to follow.
Knowing that the FTSE-100 rose, say, 15 points yesterday or two per cent last month may be reassuring but it could provide investors with a false sense of security.
The truth is that the UK stock market consists of many different kinds of companies. Shares in different segments often move in different directions at different speeds. Evaluating the market's overall health requires a bit more than monitoring a single index.
2006 serves as a good example. The FTSE-100 rose 10.7 per cent. It was a good performance but the FTSE-250 did much better, increasing by 27.1 per cent. Investors would have made almost three times as much by ignoring shares in the 100 and selecting shares within the 250.
The reason for this performance gap is partially due to the make-up of each index. A significant number of FTSE-100 shares are large multi-nationals that do much of their business outside of the UK. They are affected by geo-political and world-wide economic trends to a very great degree.
In contrast, members of the FTSE-250 index are less likely to be affected by global trends. Companies in the index are smaller than FTSE-100 constituents. Although many also have international operations, a larger portion of their total sales, costs and profits are incurred in the UK.
The UK's healthy economic performance in 2006 helps to explain performance differences between the FTSE-100 and 250. This was especially true in the second-half of the year.
But do not be too quick to switch your focus to the FTSE-250 based upon this analysis. While it provided a profitable insight during 2006, keep in mind the investment world is forever changing. The 250 may not be the right index to monitor in the weeks and months ahead.
To illustrate this point, our next graph matches the FTSE-Small Cap index against its two larger competitors. As the name implies, Small Caps are smaller than 250 companies and face different kinds of competitive pressures.
Notice that 250 companies began to flag late in the fourth quarter of 2006, relative to Small Caps. A smart investor would be wise to make note of this changing stock market trend when considering his or her next investment decision.
The recent strength of Small Caps is worth reflecting upon for a moment. Many commentators believe the current stock market cycle is very mature. In the past, this was the point in the cycle when shares of larger, dividend-supported defensive companies tended to do best. Chart 2 tells us that, so far, the stock market is not following the script.
What does the future hold, as far as this new Small Cap trend is concerned? The plain vanilla truth is that no one on the planet knows the answer. It is for this reason that serious investors must make the effort to constantly monitor several different indices, not just the one that newspaper editors decide to feature.
Monitoring different stock market indices is easy to do. This web site provides some help on the subject. Click on "prices" near the top/left of this page and then "indices" on the left side of the following page.
Now click on the graph icon for a specific index (the squiggly red line at the right). You will be able to create graphs for the index of your choice compared to any other. To be an informed investor, it pays to visit this page on a regular basis.
Even more important. Resist the temptation to make judgements about the health of the UK stock market by monitoring a single index. The UK stock market is too big and too complex to take this shortcut.