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What is S&P 500 Index?

This article describes the S&P 500 Index, what it is and why is it important for investors and traders to understand it.

The S&P 500 (Standard and Poor’s 500) index is a stock market index comprised of 500 significant businesses that trade on US stock exchanges. The S&P 500 index is capitalization-weighted. The performance of the index’s ten largest firms accounts for circa 21.8% of the index’s return. 

The S&P 500 is managed by S&P Dow Jones Indices, a joint venture that is majority owned by S&P Global, and its members are chosen by a committee. The Dow Jones 30, Nasdaq 100, and Russell 1000 are the other three major US equity indices.

It is one of the world’s most popular instruments for trading and investing. The Chicago Mercantile Exchange (CME) provides futures contracts tracking the price of the index. These futures contracts represent the most desirable asset the exchange offers. The Chicago Board Options Exchange (CBOE) provides options on the S&P 500 index as well as ETFs tracking the index, inverse ETFs, and leveraged ETFs.

Benchmark for the investing world

This index is widely recognized as the industry standard. Everyone in the investment world, including asset managers, hedge funds, investors, and traders, compares their outcomes to the S&P 500 index. The S&P 500 is commonly referred to as “the market.”

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If a portfolio manager’s annual return is greater than the S&P 500 index, we may say that he outperformed the market. If an investor fails to achieve the index’s annual return, he underperforms the market. Buying the S&P 500 index is one of the most convenient and effective methods to invest; no investment knowledge is required; you simply “go long the market” and let it carry you.

From its beginning in 1928 until December 31st, 2021, the average yearly return of the index is 11.82%. Since the inclusion of 500 stocks in the index in 1957 through December 31st, 2021, the average yearly return is 11.88%, with annual gains occurring in 70% of all years. In addition, the average yearly return has been somewhat greater over the past decade, mostly due to the US central bank’s ultra-lax monetary policies.

How is the index calculated?

As already mentioned, the S&P 500 utilizes a market-cap weighting approach, allocating a greater proportion of its weight to firms with larger market capitalizations.

The proportion of each component of the S&P 500 is determined by first calculating the total market capitalization of the index by summing the market capitalization of each firm in the index.

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To review, the market capitalization of a firm is determined by multiplying the current stock price by the number of outstanding shares. Fortunately, the overall market capitalization of the S&P 500 and the market capitalizations of individual enterprises are routinely reported on financial websites, sparing investors the trouble of calculating them. Each company’s weighting in the index is computed by dividing its market capitalization by the index’s total market capitalization.

Even though these are 500 huge corporations, there is a broad variety of valuations, which is a critical factor. Several of the index’s top firms have market capitalizations above $1 trillion. This is more than 150 times the market capitalization of the lowest S&P 500 corporations, which range from $6 billion to $7 billion.

Throughout the trading day, the value of the S&P 500 index swings continually depending on performance-weighted market data for the constituent firms.

List of companies

As previously mentioned, the index consists of 500 companies (503 stocks of the said companies), which regularly change. Here are the top 10 companies in the index as of January 2023.

#

Company

Symbol

Weight

1

Apple Inc.

AAPL

6.083397

2

Microsoft Corporation

MSFT

5.36183

3

Amazon.com Inc.

AMZN

2.551173

4

Berkshire Hathaway Inc. Class B

BRK.B

1.697686

5

Alphabet Inc. Class A

GOOGL

1.631808

6

Alphabet Inc. Class C

GOOG

1.46031

7

Exxon Mobil Corporation

XOM

1.391803

8

UnitedHealth Group Incorporated

UNH

1.356356

9

Johnson & Johnson

JNJ

1.350054

10

NVIDIA Corporation

NVDA

1.320547

You may question why the S&P 500 is regarded as such a helpful economic and financial indicator. Because the S&P 500 is a large group of stocks without too many tiny or obscure firms, it contains the companies that individual investors own the most of. The 500 largest corporations account for approximately 80% of the total value of the US stock market.

Furthermore, there are companies divided into eleven sectors, covering all the necessary parts of the US economy. Information Technology, Health Care, Financials, Consumer Discretionary, Communication Services, Industrials, Consumer Staples, Energy, Utilities, Real Estate, and Materials are listed in descending order by market capitalization.

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Sector breakdowns assist portfolio managers and investors in establishing the allocation of portfolio resources. If an investor wants to establish a diverse portfolio, he or she must include equities from several industries. However, if an investor is solely interested in investing in, for instance, technology or energy-based enterprises, they might concentrate their investments only on those areas.

As a result, the S&P 500 is the best equity index to judge the health of the US economy as a whole. On the other hand, the Nasdaq 100 index contains only tech stocks. Therefore, it does provide only limited information about the US economy.

Simple fundamental analysis of the index

Examining the S&P 500’s trailing and forward P/E ratios will offer a fast sense of whether or not the index is properly valued. The S&P 500 traded at around $4,000 in January 2023, with a trailing year P/E ratio of 21.5 and a forward P/E ratio of 20.1 (based on predicted earnings in the following four quarters).

The trailing P/E ratio of 21.5 is 21% over the long-term average of 17.7 but below the 30-year average of 23.2. The future P/E ratio of 20.1 is 14% greater than the historical average of 17.7, but it is lower than the 30-year average. Note that analysts’ future profit predictions are typically viewed as being inflated.

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Today’s still-relatively-low interest rates justify a P/E ratio that exceeds the long-term average of 17.7. There are other methods of fundamental analysis, such as comparing the S&P 500 to the US GDP, analyzing the current and future dividend yield, or using the operating earnings, for example.

Simple technical analysis of the index

As of January 2023, the index is fighting to reverse the long-term downtrend and to stay above the 200-day moving average (the blue line), as shown in the chart below. The key levels to watch are near $3,980. If the index manages to close above that level, the bear market could be over, likely followed by a strong rally toward $4,200 or possibly higher.

On the downside, the support is seen near $3,800 or possibly in the $3,700 range. Please keep in mind that technical analysis tends to change quickly and is used more for trading rather than for long-term investing.

S&P 500 daily chart

S&P 500 daily chart, source: author´s analysis, tradingview.com

Conclusion

A low-cost S&P 500 index fund is the greatest investment for the majority of investors, according to Warren Buffett, a legendary stock market investor. It is not hard to understand why. Suppose you have the time, expertise, and willingness to analyze companies properly and manage a portfolio. In that case, it is achievable to produce greater investment returns relative to the S&P 500 over the long run. 

However, not everyone has the required time and discipline to invest in stocks in this manner, and novice investors may be better off purchasing shares in an S&P 500 index fund until they gain experience. Investing in the S&P 500 is a means to gain wide exposure to the profitability of US companies without excessive exposure to the performance of any specific firm. Over time, the S&P 500 may provide substantial returns for your portfolio with little work from you.

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