What is S&P 500 Index: The exhaustive guide to Standard & Poor's 500 for newbies
What is S&P 500 Index: The exhaustive guide to Standard & Poor's 500 for newbies
11 February 2022
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One of the most significant indices on the world’s trading arena, the Standard & Poor’s 500 is commonly used by investors to define the right market entry moments. Being composed of the largest corporations, it reflects the state of the global economy. In this detailed guide, we will review what is S&P 500 is, the way to calculate it, the criteria for company inclusion and some tips for investors.
What Is the S&P 500 Index?
The Standard Poor’s 500, more commonly known as the S&P 500, is one of the three benchmark indices in the United States (alongside the Dow Jones and the Nasdaq). As its name suggests, it is made up of the 500 largest US companies (by market capitalizations).
Some consider it the most important index in the world: with over $40 trillion in market cap, it alone accounts for 80% of US market capitalization and 50% globally. Overall, this is the best indicator of how American companies perform.
Note that each included share does not represent 1/500 of the index: larger participants like Apple or Amazon have a stronger impact on S&P 500. The biggest ones have market capitalizations of over $1 trillion, while the smallest ones are estimated at a few billions.
What companies are included in the S&P 500?
To join the S&P 500, a company must be listed on the Nasdaq or the New York Stock Exchange (NYSE). In accordance with the index methodology, the following criteria must also be met:
The company’s headquarters are in the United States.
The shares should be easily tradable without affecting the price.
At least 250,000 shares must be traded each month for the past 6 months.
The free float must represent at least 50% of all the shares.
The company must show a positive cumulative profit (before tax) in the previous year with the last positive quarter.
Note that the first criterion is the most restrictive one. Thousands of companies are listed on the Nasdaq or the NYSE, but less than 1,000 have a valuation above $13 billion.
S&P 500 Sector Breakdown
With 500 stocks, the US index is quite well diversified. From the sector standpoint, we can still note the prevalence of technology stocks. This is quite logical given the dominance of the United States in this field. Next, come communication services, healthcare and consumer staples.
Alphabet Inc. A
Alphabet Inc. C
Berkshire Hathaway Class B
UnitedHealth Group Incorporated
The Weighting Formula for the S&P 500
The S&P 500 gives a higher allocation to companies with the largest market caps:
Company Weight in S&P = Company Market Cap / Total of All Market Caps
Every four months (on the second Friday of March, June, September and December), the index committee made up of professional members of the S&P Dow Jones Indices, shortlists the companies that join the index or get excluded.
As a rule, companies with the largest market capitalization are preferred but there are also additional criteria. For example, companies in the index must be identified as US-based, and their shares must be liquid (so that investors can sell and buy them quickly).
Although the structure of the S&P 500 is rebalanced quarterly, the share of each company in the index changes every day! After all, it depends on the value of the shares, which fluctuates every trading session.
Why use the S&P 500?
The main advantage of the index is its role in the global economy: the S&P 500 perfectly reflects the US market and is well diversified. Some investors challenge themselves by trying to outrun the S&P 500, however, the best results are achieved when they try to match the performance of the index.
Newcomers are recommended to practice passive management, i.e. use a buy-and-hold investment strategy. It means there’s no need to monitor the market daily and perform intraday deals. Even unexperienced traders can make returns by investing in the index funds.
The S&P 500 index is the most important indicator of the economy and the US stock market. Those who prefer it to the Dow Jones do so because the S&P 500 is much more reflective of the market, highly diversified, and calculated based on capitalization, not just price. Those who were able to “overtake” the S&P 500 index in terms of profitability are considered successful traders.
How Does the S&P 500 Compare to Other Indexes?
S&P 500 vs. DJIA
The Dow Jones Industrial Average is a major US stock market index that measures the performance of the top 30 companies listed on US stock exchanges. Unlike other stock indices, the Dow Jones only includes 30 large-cap stocks. It is not estimated by market capitalization and does not use a weighted arithmetic average.
Investors perceive the S&P 500 as more relevant to the US economy as it relies on 500 companies instead of DJIA’s 30.
DJIA uses a different formula because it is believed that weighted index calculation prevents the negative impact of a company’s performance on the rest of the index. Hence, one of the main differences between the Dow Jones and the S&P 500 is that the DJIA does not account for changes in market capitalization, as other indexes do.
S&P 500 vs. Nasdaq
Nasdaq is an index of the namesake exchange where companies from the technology sector of different countries are traded. Initially, there were about 2500 companies in the index, but Nasdaq 100 with hundred of companies is used more often. Formally, there is no focus on the USA, but most of the high-tech companies are founded in the States.
The Nasdaq 100 is broader than the Dow in a number of ways, but the influence of a small group of stocks is even more pronounced. The top 10 companies in the Nasdaq 100 account for over 50% of the index, leaving 90% of the index to account for less than half of the index’s value. Pretty much the same is true for S&P 500 where the largest companies have the biggest value on the index. But Nasdaq fluctuates stronger because of the smaller range of companies.
S&P 500 vs. Russell indexes
While S&P 500 is referred to as the broad market index for large-cap companies, Russell 2000 is the broad market index for small-cap companies.
The main differences are as follows:
The number of companies included in the index. The S&P 500 uses the shares of 500 leading companies for calculation, and the Russell 2000 uses the shares of 2000 small companies.
The capitalization of companies included in the index. The S&P 500 monitors the leading campaigns by capitalization and the investors holding portfolios of shares. Russell 2000 shows the state of small-cap companies: it is monitored by investors who have shares in minor but promising companies.
Generally, despite significant differences, over the past few years, the S&P 500 and Russell 2000 indices have shown fairly similar market dynamics.
S&P 500 vs. Vanguard 500 Fund
The Vanguard 500 Index Fund depends on the price and performance of the S&P 500 index. It is driven by investing in the stocks comprising the index - each share with the same weight as in the S&P. Hence, Vanguard 500 replicates the movements of S&P 500. This is a low-cost way to enter the US equity market.
How to Use the S&P 500 to Make Money?
How to invest in the S&P 500 index?
The easiest and most popular way to invest in the S&P 500 is to work with an exchange-traded fund that constantly monitors changes in the composition of the index and buys shares of companies in the same proportion. Investments through underlying funds save traders’ time - the stock portfolio is recalculated automatically. There are many funds on foreign exchanges that track the S&P 500 index.
Examples of S&P 500 ETFs:
S&P 500 Vanguard (VOO);
SPDR S&P 500 (SPY);
iShares Fund Core S&P 500 ETF (IVV);
iShares Fund Core S&P 500 UCITS ETF (CSPX).
These funds are often recommended to traders thanks to low management costs (for the funds listed above, fees range from 0.03% to 0.07% per year). In addition, American exchange-traded funds pay dividends, while European ones don’t.
How to trade the S&P 500 CFD
S&P 500 is characterized by higher liquidity and long trading periods. The most popular way to trade this index is using CFDs (contracts for difference). It allows you to go short or long without using traditional exchanges.
This index is not hard to track because trends can be revealed on real-time charts, and entry or exit signals can be defined with well-known indicators. Moreover, there’s a bunch of respectable investors who perform a complete technical analysis and share their thoughts on the movements of S&P, so even newbies can make smart financial decisions and trade wisely.
Limitations of the S&P 500 Index
There are a few hidden pitfalls you should be aware of:
Like any market-cap-dependent index, S&P faces limitations when one of the stocks gets overrated, i.e. rises higher than the warrant. Such stocks tend to inflate the overall index value.
Since a company’s growing market cap doesn’t necessarily reflect its real performance, it rather shows the stock’s boost in value compared to shares outstanding. Hence, indexes with equal weight can become too popular while each company’s share price move has the same impact on the index.
History of the S&P 500 Index
The history of the index originates in 1860’s, when Henry Varnum Poor founded Poor’s Publishing, which aimed to advise investors on the railroad industry. In 1923, the Standard Statistics Company started publishing a stock market index calculated on a weekly basis, with 233 companies analyzed. They merged with Poor’s Publishing in 1941 and After March 4, 1957, the index started including up to 500 stocks and was renamed in “S&P 500”.
Through decades, the index showed rather steady growth outperforming other major asset classes like bonds and commodities. It was seriously affected after World War II and fell below 700 points. During the decline of the US economy in 1969 and 1982, it was below 300 points.
The most memorable moments in the history of the S&P 500 include:
Black Tuesday/Great Crash (Sept 16, 1929 — Sept 22, 1954) were marked with a -86% drop,
First time closing above 100 on June 4, 1968.
Black Monday on October 13, 1987 had a lasting impact on the economy: the index fell by -29% in 19 months.
Nixon Shock / OPEC Oil Embargo (Jan 11, 1973 — Jul 17, 1980) with a -48% crash. First time closing above 1,000 on February 2, 1998.
Dot Com Bubble (Mar 24, 2000 — May 30, 2007) caused a -49% collapse.
Global Financial Crisis (Oct 9, 2007 — Mar 28, 2013) caused the index to fall by -57%.
First time closing above 2,000 on August 26, 2014.
First time closing above 3,000 on July 12, 2019.
COVID-19 Crash started on Feb 19, 2020 and its impact is still lasting. In 5 months after the outbreak, the event caused S&P to fall by 34%.
Closing above 4,500 on October 13, 2021.
Being closely connected with the performance of American stocks, the S&P 500 index is a key metric for investors striving to capitalize on the largest US-based companies. It is calculated in a straightforward way and tends to be easier to predict than many other indices.
The S&P 500 has been around for almost a century, so this is a tried-and-tested instrument for investors. It reflects the overall performance of American corporations and their impact on the global economy, so this index should always be taken into account when you’re analyzing the stock market.
With the IT and communication sectors gaining traction through 2020-2022 and further, we may witness a new record-breaking value of the index with US companies boosting their capitals.
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