The S&P 500: The Index You Need To Know

If you had to use a single quantity to indicate the strength of the economy, what would it be? The consumer confidence index is too subjective. The unemployment rate overstates under-the-table workers and understates discouraged workers. Even though the Dow Jones Industrial Average is the best known and most quoted stock index in the world, it’s so selective as to be misleading. Comprised of only 30 stocks, the Dow is less representative of the economy as a whole than are several other indices. Paramount among those is the S&P 500, the daily de facto numerical indicator of the U.S. economy. While the S&P 500 gets second billing even in the financial media, and little recognition elsewhere, its importance is vital.

What's in a Name?

First, the etymology of the term. "S&P" is Standard and Poor’s. Henry Poor was a 19th century financial analyst who compiled an annual book that listed publicly held railroad companies. His publication merged with those of the "Standard" Statistics Bureau in 1941. And "500" is the number of stocks that comprise the index.

That’s it. The index includes 500 of the largest (not necessarily the 500 largest) companies whose stocks trade on either the NYSE or NASDAQ. Like popes and Oscar winners, the components of the S&P 500 are selected by committee. And, like the College of Cardinals and the Academy of Motion Picture Arts & Sciences, the S&P 500 committee operates within specific criteria. To qualify for the index, a company must have:

• a market cap of $5.3 billion
• its headquarters in the U.S.
• the value of its market capitalization trade annually
• at least a quarter-million of its shares trade in each of the previous six months
• most of its shares in the public’s hands
• at least half a year since its initial public offering
• Four straight quarters of positive as-reported earnings.

Between them, the NYSE and NASDAQ list 5,900 companies (fewer than that if you restrict it to straight stocks, as opposed to master limited partnerships and other entities). But the first criterion alone reduces that number to 975, and eliminates such famous names as AOL Inc (AOL) and Tupperware Brand Corp. (TUP). Add a few more benchmarks, and it’s easy to see how the S&P can get down to 500 large-cap stocks suitable for inclusion. (For more, see: What's The Difference Between The Dow Jones Industrial Average and the S&P 500?)

Complex Math

Unlike the Dow, which you calculate by just adding up the prices of the component stocks and multiplying by a constant, the S&P 500 is more complex. Instead of adding the constituents stocks’ prices, the S&P 500 adds the companies’ float-adjusted market capitalization. “Float-adjusted” means counting only the shares available to us ordinary folk, excluding those held by management, by governments and by other companies. There are hundreds of ostensibly “publicly traded” companies that keep most of their shares in-house. (For more, see: How Is The Value of the S&P 500 Calculated?)

Shown The Door

With so many components, and such stringent criteria, the S&P 500 is dynamic. S&P Dow Jones Indices, the subsidiary of McGraw Hill Financial, Inc. (MHFI) that determines the components of the index, has little patience for slackers. United States Steel Corp. (X), one of the stalwarts of 20th century industry, had been listed on the S&P 500 since its inception. In fact, at one point U.S. Steel was the largest company in the world. Alas, it hasn’t turned a profit in years. When it fell below the $4 billion threshold in 2013, the index booted it out and made room for Martin Marietta Materials Inc. (MLM), a construction aggregate producer. Only on Wall Street does the Iron Age give way to the Stone Age. (For more, see: Where Can I Find A List of All The Stocks in the S&P 500?)

Low Turnover

But even technologically adept companies have to meet the S&P 500’s list of requirements or perish. Advanced Micro Devices Inc. (AMD) is the second-largest microprocessor producer in the world, but also fell off the index in 2013. Again, due to market cap issues. Turnover in the S&P 500 is lower than you might think — this year, only eight issues have been replaced:

That list excludes one instance of a company buying the company it replaced on the index, and another of a company spinning off a large chunk of itself. Forest Labs, Beam, and Life Technologies all got bought out by larger companies. The remaining ex-index members all fell victim to low capitalization. Typically, when that happens, the one company is relegated to the index that its replacement was promoted from. For instance, Rowan took Mallinckrodt’s place on the S&P MidCap 400.

Is there a survivorship bias here? Sure, but there’s also a survivorship bias in the economy at large. The remaining stocks flourish by virtue of remaining. One study even claims that over the decades, stocks deleted from the S&P 500 have ended up outperforming their replacements.

The Bottom Line

For the most part, the S&P 500 doesn’t convey information that differs drastically from comparable indices. It largely tracks (or vice versa) the more exclusive Dow, and the more inclusive Russell 2000. The S&P 500 represents a happy medium of sorts: comprehensive enough to indicate the relative strength or weakness of the larger economy, but not so exhaustive as to include too much noise with the signal. On balance, the S&P 500 is the index of indices — the bellwether adopted by analysts, policymakers, and ordinary market participants alike. (For more, see: How Can I Buy An S&P 500 Fund?)