Deciphering the Index Illusions (Kerry Watkins-Bradley Commentary)

The index is widely regarded as the best single gauge of the U.S. equities market.

This world-renowned index includes a representative sample of 500 leading companies in leading industries of the U.S. economy, and is the most widely used benchmark by mutual funds, money managers and individual investors when assessing stock portfolio performance.

Due to this fact, it is important to know the methodology and composition of the index.

The S&P 500 is a market capitalization weighted index. This means it is calculated using the price of each stock multiplied by the number of shares held by the public.

The companies with the highest market capitalization — such as General Electric, Microsoft and ExxonMobil — will have the greatest impact on the index.

This type of calculation has its pros and cons and could be an article in itself which is better left to a later date.

The S&P 500 Index is broken down into 10 different economic sectors, those being:

Financials – banks, insurance, consumer finance

Information Technology – computer-related industries and electronic equipment

Healthcare – pharmaceuticals, medical supplies and services

Consumer Discretionary – automobiles, household goods, textiles, media and retail

Industrials – transportation, aerospace and defense, construction and machinery

Consumer Staples – beverages, food, tobacco and personal products

Energy – oil and gas drilling, exploration and refining

Utilities – electric, natural gas and water suppliers and power producers

Communication – cellular, wireless, long distance and telephone

Materials – chemicals, packaging, mining, paper and forestry products

The number of companies in each sector changes as companies are added and removed from the index. Understanding the makeup and shifts in the index over time can give an investor valuable insight into the health of the market.

The graph on this page depicts the index weightings of the five different economic sectors with the largest weightings change over the past six years.

It’s interesting to take a look back and dissect the index over the past six years since it has been such a roller coaster. As you can see, in 1999, information technology and communications combined to represent over 37 percent of the S&P 500 index in the heyday of the tech bubble.

Currently, they make up less than 20 percent, and at the bottom of the correction, in the fall of 2002, they represented less than 16 percent.

Conversely, financials made up less than 12 percent of the index when technology was flying high, but now represents the largest part of the index with a weighting of over 20 percent.

The performance of the stocks that make up the sectors play a large part in the fluctuations. For instance, the energy sector has been the big winner in 2005 with returns north of 25 percent year to date.

The gains this year alone have increased the sector’s weighting by 35 percent to now represent 9.5 percent up from 7 percent at the beginning of the year, and less than 5 percent back in 2000.

In 1998 and 1999, the S&P 500 index returned +28.58 percent and +21.04 percent, respectively. However, the information technology sector produced returns of +78.14 percent and +78.74 percent in those respective years.

With information technology representing roughly 30 percent of the index, it aided greatly in the stellar returns in the index as a whole and helped mask some of the underlying weakness in other parts of the market.

And as we found out when the tech bubble burst, earnings and valuations in the tech sector were pushed to extremes and quickly deflated over the next several years.

Even though the S&P 500 Index is probably the most widely followed barometer for U.S. equities, it can occasionally paint a skewed picture of the state of the market. By looking at the make up of the index, one can get a much better understanding of what’s going on in the economy and driving stock prices.

While it is always good to have a benchmark in which to gauge your investment performance, it’s also just as important to stay focused on reaching your long-term goals regardless of how your portfolio performed in a single quarter or year.

Always remember to stay focused on your ultimate objectives and that things may not always be as straightforward as they appear.

(Kerry Watkins-Bradley, CFA, MBA, is equity portfolio manager at Garrison Financial in Fayetteville. E-mail her at [email protected].)