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Why the S&P's Record High Isn't as Important as You Think

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Yesterday, the S&P 500 (SNPINDEX: ^GSPC  ) hit a new record high for the first time since 2007. In light of all the other market benchmarks that have been setting records left and right lately, the addition of the S&P might not seem to be all that big a deal; but many analysts have argued that the S&P's record has special significance.

Despite the hype, the S&P 500's record close yesterday shouldn't lead you to make any monumental moves in your portfolio. Here are some reasons why:

1. The S&P isn't as broad-based an index as it looks.
One of the big arguments in favor of using the S&P 500 as the leading measure of the U.S. stock market is that it includes a wide set of companies. With 500 of the largest companies in the nation, the S&P 500 fairly represents the breadth of the U.S. economy, including proportionate exposure to every industry in the market. That differentiates it from other popular indexes like the Dow and the Nasdaq-100, each of which tends to have skewed exposure toward certain industries and companies, and away from others of arguably equal or greater importance.

But, when you look more closely at the S&P, you'll notice that a relatively small number of companies are responsible for a huge part of its overall value. The top 10 stocks in the index account for nearly 19% of its value, and its largest component has a weighting of more than 3%, compared to just 0.01% for several of its smallest components. That makes the index highly dependent on megacap stocks, and has led some investors to use equal-weight funds in lieu of the market-cap weighted S&P.

2. The S&P's index value doesn't reflect its actual returns.
Many investors rely too much on closing values of indexes as gauges of their returns. Yet, two big factors that have an impact on returns routinely get ignored by those focusing solely on index levels.

On one hand, dividends aren't reflected in the S&P's closing record. With a yield of roughly 2.1%, investors who've relied solely on index funds tracking the S&P 500 have earned a modest, yet substantial, positive rate of return since late 2007, even if the index's value is almost identical to its former closing high. Alternative market measures incorporate total return, but those measures aren't among the popular benchmarks investors are most familiar with.

At the same time, inflation also gets ignored by the raw index value of the S&P. Lately, inflation hasn't been a huge concern, but the roughly 2% annual rate of inflation over the past five years has nevertheless wiped out most of the dividend income that the stocks in the index have paid to investors.

3. The S&P's earnings are much different than they were in 2007.
In assessing the market's future course, it's tempting to look at what happened the last time the S&P 500 was this high. We all know far too well what came next back then: The financial crisis led to a massive market implosion that took more than 50% of the S&P's value away over the ensuing 18 months.

But the fundamentals underlying stocks are much different this time around. Back in 2007, the stocks in the S&P produced about $82.50 per S&P-weighted "share" in earnings and, based on the S&P's record close in that year, the index traded at about 19 times earnings back then. In 2012, however, the S&P's earnings soared to almost $102.50, meaning that, even at today's record, we're only at 15 times earnings. Moreover, analysts expect even bigger earnings gains this year.

Moreover, we can arguably be more confident about earnings now than we should have been back in 2007. Looking back, earnings for financial giants JPMorgan Chase (NYSE: JPM  ) , Bank of America (NYSE: BAC  ) , and Wells Fargo (NYSE: WFC  ) were misleadingly high, as they all eventually suffered huge losses in ensuing years. In hindsight, the problems that those banks had were building up, even as the S&P rose to new heights; but the full impact of their missteps didn't hit their earnings until later. Although some would argue that similar problems may be hiding among balance sheets today, we've nevertheless come a long way toward getting accounting issues out into the open.

Stay calm and invest on
So, even as the news trumpets the fact that the S&P 500 has hit new record highs, be sure to keep your investments in perspective. Making too much of records will distract you from having an overall long-term investing plan that covers bull markets and bear markets alike.

With JPMorgan and other banks still trading at deep discounts to their historic norms, investors everywhere are wondering if this is the new normal, or whether financial stocks are a screaming buy today. The answer depends on the company, so to help figure out whether JPMorgan is a buy today, I invite you to read our premium research report on the company today. Click here now for instant access!


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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