The ABCs of the S&P
by Ethan Haskel ([email protected])
Baltimore, MD. (Oct. 28, 1998) -- The primary objective of the Beating the S&P (BSP) strategy (and many others in the Workshop) is to outperform its arch-nemesis, the Standard & Poor's 500 Index. But what exactly is the S&P 500 Index? I'd like to take an intermission from our ongoing discussions about the creation of BSP to focus a little more on this underappreciated benchmark.
The S&P 500 Index differs from its more popular rival, the Dow Jones Industrial Average (DJIA), in many ways. As we discussed previously, the DJIA consists of 30 of the largest American market-leading stocks in the United States, chosen mainly for size and diversity considerations. The value of the Dow 30 Index is price-weighted, meaning that to find the value of the DJIA, one merely has to add up the price of all 30 member stocks and divide by a set denominator. (This denominator changes depending on stock splits, component substitutions, spin-offs, etc.)
The S&P Index was created in 1923, when it originally comprised 233 stocks belonging to the leading industry groups of the time. Since then, the index has evolved to comprise 500 stocks of American companies, chosen by the S&P 500 Index Committee. The primary considerations in choosing these companies seem to be market capitalization, diversity (to mimic the overall composition of U.S. economic activity), and financial stability.
Unlike the Dow 30, utilities and transportation companies are included among S&P 500 stocks. In fact, 37 companies in the current index are utilities, while 10 are transportation-related. Also, unlike the present Dow, the S&P 500 doesn't remain wedded solely to companies listed on the New York Stock Exchange -- 37 of the S&P 500 companies live on the Nasdaq, while two hang out on the American Stock Exchange.
Besides the larger number of stocks in the S&P 500 than in the Dow, a major difference between the two indexes is that the S&P 500 Index is market-weighted rather than price-weighted. The contribution of any one company of the S&P 500 is determined by its market capitalization, or the stock price multiplied by the number of outstanding shares, not merely its stock price.
To determine the value of the S&P 500 Index, one needs to know the market capitalization of each of the 500 member components and add them up. It's the sum of these capitalizations that determine the value of the index from day to day. An adjustment formula is used each time an index stock is substituted, involved in a spin-off, makes an acquisition, or pays a dividend.
Most observers agree that a market-weighted index such as the S&P 500 is preferable to the price-weighted formula used by the Dow. For instance, two stocks in the Dow 30 are General Electric (NYSE: GE) and United Technologies (NYSE: UTX). The market capitalization for GE is about 15 times that of UTX; as of this writing, the current stock price for both is in the 80 dollar range. If GE should lose a dollar tomorrow while United Technologies gains a buck, the Dow Index would record this as a neutral event, since the sum of the stock prices would not change. The relatively obscure defense company carries the same influence as the behemoth that brings good things to life.
Most would agree that General Electric and United Technologies should not share equal influence as a proxy for the value of American stocks. The S&P 500 Index remedies the distortions inherent in its older Dow sibling and by its very breadth tends to be more representative of U.S. economic activity as a whole. In fact, the total capitalization represented by the companies of the S&P 500 is almost 90% of that of the entire New York Stock Exchange!
Because the S&P 500's company inclusion criteria rely heavily on market capitalization, one of its potential weaknesses is that it doesn't adequately represent the fortunes of the other 9500 or so stocks listed on the major exchanges. For those wanting a better benchmark with which to measure these smaller fries, try the Russell 2000, or the S&P MidCap 400 or SmallCap 600 indexes.
There you have it... the ABCs of the S&P!
Have a safe and scary Halloween.
[NOTE -- Due to the fact that Value Line has still not corrected their file, we've decided not to provide the database and rankings for last week. We know this inconveniences people, and we apologize. Unfortunately, this is beyond our control, and we'd rather provide no data than bad data. Thank you for your patience.]