S&P 500 Index Essay

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The S&P 500 Index or the Standard & Poor’s 500 Stocks Composite Index is a market value–weighted index of 500 leading U.S. large market capitalization or large cap stocks. The S&P 500 Index is widely regarded as the principal indicator of overall stock market activity in the United States and commonly serves as a proxy for the entire U.S. equity market. The S&P 500 evolved in various stages from 26 original industrial indices comprised of 233 stocks that were first developed by Standard & Poor’s Corporation in 1923 to 416 stocks representing 72 industrial indices in 1941. The sample of stocks was increased from 416 to 500 in 1957 to create the S&P 500. Initially, three broad economic sectors were included in the index: 425 industrial companies, 60 utilities, and 15 railroads. In 1976 the index was revised to include some NASDAQ-listed companies, primarily insurance companies and commercial banks, resulting in an index composed of 400 industrial companies, 40 utilities, 40 financial companies, and 20 transportation companies. In 1988 the number of economic sectors represented in the index was expanded to become more representative of the U.S. economy. In May 2008 the economic sector breakdown of the index, based on the Global Industry Classification System (GICS), which includes 10 economic sectors, was as follows: Financials (92 companies); Consumer Discretionary (86); Information Technology (71); Industrials (56); Health Care (51); Consumer Staples (40); Energy (36); Utilities (31); Materials (28); and Telecommunication Services (9). In May 2008, 423 of the 500 stocks in the index were listed on the New York Stock Exchange, representing 84.1 percent of the index’s market capitalization. The remaining 77 firms were listed on the NASDAQ.

An eight-member S&P Index Committee comprised of Standard & Poor’s staff meets monthly to maintain the index and consider additions and removals of constituent companies according to published criteria. Eligibility criteria for a company’s selection to the index include: (1) market capitalization of US$5 billion or more; (2) market liquidity for its shares as evidenced by a ratio of annual share turnover to market capitalization of 0.3 or more; (3) U.S. incorporation or otherwise considered a U.S. company; (4) public float, or shares available for trading, of at least one-half of shares outstanding; (5) contribution to the index’s economic sector balance based on GICS, which includes not only 10 economic sectors, but also 24 industry groups, 67 industries, and 147 subindustries; (6) financial viability, commonly measured as four consecutive quarters of profitability; (7) publicly traded for 6 to 12 months; and (8) an operating company as opposed to, for example, a holding company or investment vehicle. Companies can be deleted from the index for failure to meet the above eligibility criteria, including violations that result from corporate restructuring.

As a value-weighted index, the S&P 500 Index is calculated by (1) multiplying each stock share’s current price by the number of float-adjusted shares outstanding or shares outstanding that are available to investors; (2) summing each of these 500 products based on current share prices; (3) then multiplying each stock share’s base price in the base period by the number of outstanding shares in the base period; (4) summing each of these 500 products from the base period; (5) dividing the sum of the 500 products based on current share prices by the sum of the 500 products in the base period; and (6) multiplying this result by the beginning index value or base value, which in the calculation of the S&P 500 Index is 10. The S&P 500 uses a base period dated from 1941 to 1943. Should a company have multiple classes of stock, S&P uses only one of them, commonly the most liquid class, in its calculation of the index. Changes to the index are made when needed and are announced two to five days before their implementation.

Researchers have discovered that a company’s inclusion in the S&P 500 results in positive abnormal returns on the stock. Among the explanations for this phenomenon are new demand pressures from large block orders for the stock, improved liquidity in the market for the stock as the result of increased institutional investor ownership, increased monitoring of the firm leading to improved operating performance, and increased investor awareness about the stock as a result of its inclusion in the index.

The S&P 500 Index is widely used as benchmark for performance for fund and portfolio managers, individual investors, and financial analysts. “Beating the market” commonly is a reference to earning returns exceeding those reported by the S&P 500 in any given time period. Fund and portfolio managers’ performance in the equity markets for any period is often measured in comparison to the return in the equivalent period on the S&P 500 Index. The return on the S&P 500 Index often serves as the proxy for the return on the overall U.S. equity market in the determination of individual firms’ cost of equity capital in capital budgeting and firm valuation calculations. Equity and credit analysts rely upon financial ratios calculated for the S&P 500 Index or its constituent economic sectors as a basis on which to compare and assess individual companies’ performance.

The S&P 500 Index also serves as one of 10 leading economic indicators released monthly by the Conference Board. The rationale for its inclusion is that as a broad measure of U.S. equity markets, it reflects both investor beliefs and interest rate movements, which are viewed as future economic activity indicators.

Bibliography:

  1. Conference Board, Business Cycle Indicators Handbook (Conference Board, 2005);
  2. William B. Elliott, Bonnie F. Van Ness, Mark D. Walker, and Richard S. Warr, “What Drives the S&P 500 Inclusion Effect? An Analytical Survey,” Financial Management (December 2006);
  3. Jack C. Francis and Robert Ibbotson, Investments: A Global Perspective (Prentice Hall, 2002);
  4. Frank K. Reilly and Keith Brown, Investment Analysis and Portfolio Management (Thomson South-Western, 2005);
  5. Standard & Poor’s, S&P 500 (Standard & Poor’s, 2007);
  6. Standard & Poor’s, S&P U.S. Indices: Index Methodology (Standard & Poor’s, 2007);
  7. Standard & Poor’s, Understanding Sectors (Standard and Poor’s, 2005);
  8. Standard & Poor’s Indices, “S&P 500 Month End Data,” www2.standardandpoors.com (cited March 2009).

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