Why Does Everyone Talk About the S&P 500?
Whether or not you are involved in investing or finance, the S&P 500 is a name that almost all of us have heard of. It is used by financial advisors helping you plan long term wealth generation and by news anchors reporting on the state of the economy. Simply put, the Standard & Poor 500 Index is a representation of the US stock market. It tracks the performance of approximately 80% of the wealth in the US economy and therefore acts as a marker for how well the US economy is performing. In this article we will answer the following questions:
- How did the S&P 500 begin?
- Which companies are in the S&P 500 and how are they selected?
- How is the index value calculated?
- Why is the S&P 500 so important?
How did the Standard and Poor 500 begin?
In 1860, Poor Publishing was founded as an investor's guide to the US railroad industry and over 60 years later Standard Statistics Company created its first index that tracked 233 US-listed companies and gave a weekly rating. In 1941, there was a merger between these two companies which resulted in the creation of Standard and Poor. It wasn’t until 1957 that the weekly stock index was expanded to 500 companies and renamed the index to the Standard and Poor 500 Stock Composite. This is the S&P 500 index that we think of today. Since then the index has remained largely the same but the biggest change was to the method weighting in 2005. It was in 1976 that Vanguard created the first retail index mutual fund which tracks the S&P 500 to this day (the fund is now called Vanguard 500 Index Fund).
Which companies make up the S&P 500?
How are companies selected for the S&P 500?
As the title might suggest, the index is made up of 500 of the largest publicly-traded companies in the US. The S&P 500 is selected by a committee, boringly named the S&P 500 committee, and they use a specific set of evaluation criteria to make their decisions. These guidelines are as follows:
- A Market capitalization of $8.2 billion (as of Jan. 2020 guidance)
- Have its headquarters in the U.S.
- The value of its market capitalization must trade annually
- At least a quarter-million of its shares trade in each of the previous six months
- At least a year since its IPO (Initial Public Offering)
- The sum of its most recent quarter and trailing four consecutive quarters’ earnings must be positive.
How often do S&P 500 companies change?
Generally, changes are made by the committee on a quarterly basis. This includes changes to the company weights and other factors, as well as the addition of new companies. However, changes can occur between quarters if a company is no longer eligible to stay in the index. These types of changes occur due to mergers/takeovers, spinoffs, change of country headquarters, and other factors listed in the above criteria. The S&P board announce these changes before they happen which allows fund managers to alter the index mutual funds they control to accurately reflect the index. Approximately, the turnover is about 25 stocks per year but it has been as high as 60.
Which companies are currently in the S&P 500?
Given that the S&P 500 represents roughly 80% of the total US market capitalization, almost all big US companies are in there. As you might expect the top 5 weighted companies are the big tech companies, namely Apple, Microsoft, Amazon, Facebook, and Alphabet (Owners of Google and Youtube among others). There are some surprising omissions from the S&P 500 that may shock you given their market capitalization and fame. Electric car manufacturer Tesla misses out with a market cap of over $300 billion along with Zoom, DocuSign, and Square. This means that those holding S&P 500 index funds will miss out any gains by these companies. However, the S&P 500 committee have done a pretty good job of tracking the US market over the years so won’t question their strategy.
Here’s a list of the top 20 companies in the current S&P 500:
- Berkshire Hathaway
- Johnson & Johnson
- Procter & Gamble
- UnitedHealth Group
- JPMorgan Chase & Co
- Home Depot
- Walt Disney
How is the S&P 500 Index Calculated?
The index value is calculated using a free-float market capitalization-weighted methodology. The first step in this method, the free-floating (publicly-traded stock) market capitalization is calculated by multiplying each company stock price by the number of outstanding shares. All of these free-floating market caps are summed together and divided by the divisor. It's important to note that this index only accounts for publicly traded shares and so only counts public shares in the calculation. The divisor is used to more accurately assess market conditions and bring the number down to a reasonable figure. To approximately determine the weight of an individual company simply divide the company’s market capitalization by the total market capitalization in the index.
The value of the index is created using the following calculation:
S&P 500 Index Level = ((Pi Qi)) / Divisor
Pi = Price of each stock
Qi = Number of publicly available share
Divisor = A mathematical factor used to factor in market conditions
Why does everyone talk about the S&P 500?
The Standard and Poor 500 index is widely considered to be the best portrayal of the US market. It is therefore a fantastic indicator of size, character, and health of the US economy - the largest in the world. The growth of the S&P 500 has accurately tracked the economy of the US economy almost since its beginning. The S&P 500 has also become the standard investment vehicle for passive investors through index funds that seek to emulate its performance. Passive investments are ‘sit-and-wait’ investments that are used to accumulate wealth in the long run rather than being traded frequently by trying to time the market.
So to summarize, the S&P 500 was created by the merger of a rail industry reporting company and a statistics firm in the early 1900s. In 1957, they created a new index with 500 of the largest companies in the US to track the performance of publicly listed US companies. The value of the index is taken by weighting the market capitalization of a selected group of the biggest American firms. And why does no one shut up about it? Simply put, it is equivalent to reading the table of a sports league for determining how well the US economy is faring.