S&P 500 Index Explained

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S&P 500 Index – Standard & Poor’s 500 Index

What Is the S&P 500 Index?

The S&P 500 or Standard & Poor’s 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies. The index is widely regarded as the best gauge of large-cap U.S. equities. Other common U.S. stock market benchmarks include the Dow Jones Industrial Average or Dow 30 and the Russell 2000 Index, which represents the small-cap index.

Standard And Poor’s 500 Index

Weighting Formula and Calculation for the S&P 500

The S&P 500 uses a market capitalization weighting method, giving a higher percentage allocation to companies with the largest market capitalizations. 

Determination of the weighting of each component of the S&P 500 begins with summing the total market cap for the index.

  1. Calculate the total market cap for the index by adding all the market caps of the individual companies.
  2. The weighting of each company in the index is calculated by taking the company’s market capitalization and dividing it by the total market cap of the index.
  3. For review, the market capitalization of a company is calculated by taking the current stock price and multiplying it by the company’s outstanding shares.
  4. Fortunately, the total market cap for the S&P as well as the market caps of individual companies is published frequently on financial websites saving investors the need to calculate them.

Key Takeaways

  • The S&P 500 Index or the Standard & Poor’s 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies.
  • The S&P is a float-weighted index, meaning company market capitalizations are adjusted by the number of shares available for public trading.
  • The index is widely regarded as the best gauge of large-cap U.S. equities. As a result, there are many funds designed to track the performance of the S&P.

S&P 500 Index Construction

The market capitalization of a company is calculated by taking the current stock price and multiplying it by the outstanding shares. The S&P only uses free-floating shares, meaning the shares that the public can trade. The S&P adjusts each company’s market cap to compensate for new share issues or company mergers. The value of the index is calculated by totaling the adjusted market caps of each company and dividing the result by a divisor. Unfortunately, the divisor is proprietary information of the S&P and is not released to the public.

However, we can calculate a company’s weighting in the index, which can provide investors with valuable information. If a stock rises or falls, we can get a sense as to whether it might have an impact on the overall index. For example, a company with a 10% weighting will have a greater impact on the value of the index than a company with a 2% weighting.

The Widely Quoted S&P 500

The S&P 500 is one of the most widely quoted American indexes because it represents the largest publicly traded corporations in the U.S. The S&P 500 focuses on the U.S. market’s large-cap sector and is also a float-weighted index, meaning company market capitalizations are adjusted by the number of shares available for public trading.

S&P 500 vs. DJIA

The S&P 500 is often the institutional investor’s preferred index given its depth and breadth, while the Dow Jones Industrial Average has historically been associated with the retail investor’s gauge of the U.S. stock market. Institutional investors perceive the S&P 500 as more representative of U.S. equity markets because it comprises more stocks across all sectors (500 versus the Dow’s 30 Industrials).

Furthermore, the S&P 500 uses a market capitalization weighting method, giving a higher percentage allocation to companies with the largest market capitalizations, while the DJIA is a price-weighted index that gives companies with higher stock prices a higher index weighting. The market capitalization-weighting structure is more common than the price-weighted method across U.S. indexes.

S&P vs. Russell Indexes

The S&P 500 is a member of a set of indexes created by the Standard & Poor’s company. The Standard & Poor’s set of indexes are like the Russell index family in that both are investable, market-capitalization-weighted (unless stated otherwise, like equal-weighted) indexes.

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However, there are two large differences between the construction of the S&P and Russel families of indexes. First, Standard & Poor’s chooses constituent companies via a committee, while Russell indexes use a formula to choose stocks to include. Second, there is no name overlap within S&P style indices (growth versus value), while Russell indexes will include the same company in both the “value” and “growth” style indexes.

Other S&P Indices

The S&P 500 is a member of the S&P Global 1200 family of indices. Other popular indices include the S&P MidCap 400, which represents the mid-cap range of companies and the S&P SmallCap 600, which represents small-cap companies. The S&P 500, S&P MidCap 400 and S&P SmallCap 600 combine to create a U.S. all-capitalization index known as the S&P Composite 1500.

S&P 500 vs. Vanguard 500 Fund

The Vanguard 500 Index Fund seeks to track the price and yield performance of the S&P 500 Index by investing its total net assets in the stocks comprising the index and holding each component with approximately the same weight as the S&P index. In this way, the fund barely deviates from the S&P, which it is designed to mimic.

The S&P 500 is an index, but for those who want to invest in the companies that comprise the S&P, they must invest in a fund that tracks the index such as the Vanguard 500 fund.

Limitations of the S&P 500 Index

One of the limitations to the S&P and other indexes that are market-cap weighted arises when stocks in the index become overvalued meaning they rise higher than their fundamentals warrant. If a stock has a heavy weighting in the index while being overvalued, the stock typically inflates the overall value or price of the index.

A rising market cap of a company isn’t necessarily indicative of a company’s fundamentals, but rather it reflects the stock’s increase in value relative to shares outstanding. As a result, equal-weighted indexes have become increasingly popular whereby each company’s stock price movements have an equal impact on the index.

S&P 500 Market Cap Example

In order to understand how the underlying stocks affect the S&P index, the individual market weights must be calculated, which is done by dividing the market capitalization of each company by the total market capitalization of the index. Below is an example of Apple’s weighting in the index:

  • Apple Inc. (AAPL) reported 4,801,589,000 basic common shares in its fourth quarter 2020 earnings report and had a stock price of $148.26 at that time. 
  • Apple’s market capitalization was $711.9 billion (or 4,801,589,000 * $148.26). The $711.9 billion is used as the numerator in the index calculation.
  • The S&P 500 total market cap was approximately $23 trillion, which is the sum of the market capitalizations for all of the stocks in the index.
  • Apple’s weighting in the index was 3% and is calculated as follows: $711.9 billion/$23 trillion.

Overall, the larger the market weight of a company, the more impact each 1% change in a stock’s price will have on the index.

S&P 500 Index

Formally known as the S&P 500 Composite Stock Price Index, the S&P 500 was introduced in 1957 and was initially a market capitalization weighted index but switched to being a float weighted index in 2005. The index consists of 500 stocks traded on the New York Stock Exchange (NYSE), American Stock Exchange (AMEX) and the Nasdaq National Market System (NASDAQ) and is the industry standard for portfolio performance benchmarking. Mutual funds which are unable to beat the S&P 500 are considered to be underperforming.

The S&P 500 comprises leading companies that are representative of various industries in the United States economy. No coincidence that many of the component stocks are large cap companies with average market capitalization of about $26 billion. Total market capitalization of all the companies in the S&P 500 exceeds $11 trillion.

Selection

The selection process is performed by an autonomous S&P Index Committee. No company can apply or be nominated for inclusion into the index.

Addition Criteria

  1. Only U.S. companies can be included.
  2. Adequate liquidity with reasonable stock price.
  3. Market capitalization of $5 billion and above.
  4. Financial viability, typically measured as four consecutive quarters of positive reported GAAP earnings.
  5. Public float of at least 50%.
  6. IPOs can only be considered 6 to 12 months after their launch.
  7. Company must not be a closed-end fund, holding company, partnership, investment vehicle or royalty trust. REITs and BDCs are eligible for inclusion.
  8. Sector balance for the index must be maintained after inclusion of the company.

Companies that meet the above criteria are placed in a replacement pool, ready to be included into the index when there is a vacancy.

Deletion

Standard & Poor believes that turnover in index membership should be avoided whenever possible. Hence companies which were added to the index usually stays in the index unless too many of the addition criteria has been violated or if the company no longer exist due to mergers and acquisitions.

S&P MidCap 400 & S&P SmallCap 600

Smaller companies have high reward/high risk profiles while larger companies typically have a low reward/low risk profiles. Hence the size of a company is a determinant of asset class but because S&P 500 companies are predominantly large and mid caps, the S&P MidCap 400 and S&P SmallCap 600 indices were introduced. S&P MidCap 400 comprises companies with market capitalization of between $1.5 billion and $5.5 billion while S&P SmallCap 600 comprises companies with market value of between $300 million and $2 billion. Together, they combine to form the S&P 1000 index.

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S&P 500 Cash Index Chart Analysis

Monthly S&P 500 cash index chart

The monthly S&P 500 cash index chart has been above its 20 month exponential moving average for 39 months. It has only been above it for more time once in the past 50 years.

The monthly chart of the S&P 500 cash index has been above the 20 month exponential moving average for 39 months. There are only 2 comparable instance of this in the past 50 years. In 1998, the S&P cash index held above its moving average for 44 months. It then fell 22% in its test down to the average price.

That rally began with the Republicans taking over the House of Representatives in 1995, and it was the strongest rally on the monthly chart in my 28 years of day trading. The current rally is occurring much later in a bull trend, which means that there is more risk of exhaustion and less likelihood of the rally lasting longer than any prior rally above the moving average. This makes it less likely that it will hold above the average as long as it did in 1998. If it holds above it for 44 months, then the touch of the moving average would be in February, and the top would probably be at least a month or two before. If it touches the moving average in fewer months, then the top would be even earlier, like within the next few months.

The only other time when the stock market held above its moving average for 38 months was in October 1987. The Crash resulted in the monthly cash index testing below the moving average in the 39th month.

While I doubt the market will crash now, the odds are probably 80% that it will reach the moving average before February, and probably within the next few months. Since the moving average is about 200 points below the high, this means that there is about an 80% chance of at least a 10% correction within the next several months. The S&P cash index corrected 36% after the 1987 rally and 22% after the 1998 rally. I believe that means that the current rally will probably correct about 20% over the next year, which would put it below the October low.

Whenever the stock market does something unusual, the move is unsustainable and therefore climactic. Even though the S&P cash index has been sideways for 7 months, it is still doing something that is unsustainable (holding above its moving average for an exceptional length of time), and it is therefore in a buy climax. The guideline I use is that whenever there is a climax, I expect about or at least a 10 bar sideways or opposite move lasting 10 bars and having 2 legs. Since this is a buy climax on the monthly chart, I am looking for 10 months (about a year) correction having at least 2 legs sideways to down.

Why am I using a 20 month exponential moving average? There is nothing magical about it. I could use a 50 month moving average. If I did, maybe the stock market would have to be above it for 60 months to be comparably overbought. If I used a 10 month moving average, maybe 20 months without touching it would be extreme. It does not matter which average a trader uses to determine whether a market is overbought. Just count how many bars the market has held above or below the average, and compare the current situation to past times. If the current behavior is extremely unusual, then it is unsustainable and climactic, and the odds favor a reasonably strong unwinding of the extreme behavior.

Although a 20% reversal would be a bear trend on the daily chart, it would probably create a bull flag on the monthly chart. It is unlikely that any major reversal would go straight down without testing up first. Even if the reversal down is more than 20%, the odds are that the stock market would test back up after the selloff, and not crash.

Although there is an 80% chance of at least a 10% correction, the stock market has been in a tight trading range for 7 months. It would only do that if the bulls and bears were perfectly balanced. This means that there is a 50% chance of a bull breakout and a 50% chance of a bear breakout. This does not chance the 80% chance of at least a 10% correction this year. There is time for a bull breakout, and it could last a month or two. However, if it happens, the odds are still 80% that there will be a 10% or more correction, which means that the bull breakout has a high probability of failing soon after it occurs.

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