When the average person talks about the stock market, chances are that person is referring to the S&P 500.
Composed of the biggest and best companies in the United States, this marquee index is one of the most widely cited and tracked economic benchmarks ever invented. Not only is it considered a leading indicator of future economic activity, but it's also the arbiter of personal wealth for many Americans whose retirement savings are pegged to it in one fashion or another.
It's for these reasons that the S&P 500 is referenced everywhere. The previous day's closing level is quoted on the front page of newspapers. Evening news programs cite it. And legions of financial professionals, particularly money managers, use the index to gauge their own performance, as well as that of competitors.
What is the S&P 500?
While it may not seem like it now, the creation of an index to track stock values was at one time a revolutionary concept. The predecessor to the S&P 500 was initiated in 1923, when a company named Standard Statistics developed the first "widely published capitalization weighted index in the United States," covering 233 U.S.-based companies. It was expanded to include 500 companies in 1957.
In its current form, the S&P 500 is an index of large-cap stocks -- each with a market capitalization of $5.3 billion or more -- that are based in the United States and trade on either the New York Stock Exchange or the Nasdaq. In short, it tracks the share prices of the 500 largest and most profitable publicly traded companies in America.
Its components run the gamut of business models, sectors, and industries. On one end of the continuum is Apple, the innovative tech company behind the iPhone, the iPad, and iTunes. On the other end is the Apartment Investment and Management Company, a real estate investment trust that "engages in the acquisition, ownership, management, and redevelopment of apartment properties."
How big is the S&P 500?
To describe the S&P 500 as "big" doesn't do it justice. In addition to being the most widely followed equity index in the U.S., it's arguably the best-known economic indicator in the world. According to Standard & Poor's, more than $5.14 trillion is benchmarked to the index via exchange-traded funds and other investment vehicles designed to mimic the broader market.
On top of this, even though the index tracks only 500 stocks out of the thousands that trade on U.S. exchanges, it captures about 80% of all available market capitalization -- which is why it's regarded as one of the best indicators of the broader U.S. economy.
How does the S&P 500 work?
Multiple companies are added to and subtracted from the S&P 500 every year. In 2013, J.C. Penney, Dell, and Abercrombie & Fitch, among others, were stripped of the coveted designation and replaced by Allegion, Transocean, and Alliance Data Systems, respectively.
The Standard & Poor's U.S. Index Committee is responsible for deciding which companies should be included in the index, and its decision is guided by five requirements:
- Its market capitalization must exceed $5.3 billion.
- Its stock must be sufficiently liquid.
- It must be domiciled in the U.S.
- At least 50% of its shares must be available for trading by the general public.
- It must be financially viable -- that is, "the sum of the most recent four consecutive quarters' as-reported earnings should be positive."
Once on the index, a company is accorded a weighting commensurate with its market capitalization. The bigger the company, the bigger the influence. On the high end are stocks such as Apple, ExxonMobil, Microsoft, and Johnson & Johnson, which command a cumulative weighting of nearly 10%. Meanwhile, companies such as Urban Outfitters, AutoNation, and Peabody Energy barely register on the scale, with individual weightings of 0.02% each.
What drives the S&P 500?
Since mounting an unprecedented ascent in the aftermath of World War II, the S&P 500 has delivered extraordinary returns. At the beginning of 1950, the index value was a mere 17. Halfway through 2014, the index was near 2,000. That equates to a return of roughly 11,000%, excluding dividends.
In hindsight, it's clear that two forces fueled this remarkable performance -- and, for the record, these continue to exert the same influence on the S&P 500 today. First, it's an axiom in investing that the interest rate on risk-free government bonds is inversely correlated to the price of all other investments, including stocks. So, because interest rates have been on a gradual decline for more than three decades, the stock market has responded by moving higher.
And secondly, rising corporate profits -- both on an absolute basis and as a percentage of gross domestic product -- have also had a positive influence on equity levels. In the 1950s, corporate earnings were anywhere between 5% and 7% of U.S. GDP. The same figure nowadays is in the neighborhood of 10%, even as GDP has grown from less than $500 billion to more than $15 trillion over the same time period.
The bottom line on the S&P 500
When it comes to investing, it's hard to deny the core role of the S&P 500. It's the backbone of the American equities markets and has long given retail investors the opportunity to participate in the growth of both domestic corporations and the broader economy. Will it continue to do so going forward? In short, there's little reason to believe that it won't.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Apple, Johnson & Johnson, and Urban Outfitters and owns shares of Apple, Johnson & Johnson, Microsoft, and Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.