S&P 500 Irrationality?
I saw something interesting today on Facebook. A colleague noted that the S&P 500 (the index of the 500 largest US companies) is currently (7/22/2020) higher than at the beginning of the year. January was a long time ago, but remember back. It was pre-COVID around the world. At that time, it was being called the Wuhan virus and it was basically a localized event in the Wuhan area of China. It wasn’t until March when the market took a nose-dive. Given that we are currently experiencing a, so-called, resurgence of the virus and states are mandating masks in public and closing public spaces again what is causing the S&P 500 to rise like it has been?
My first reaction was to say that the markets simply aren’t rational. People are doing things that just don’t make sense because we are living in a time that simply doesn’t make sense. Then I read a reply that did make sense. A graph that showed the top performing stocks in the S&P index.
Before I show the graph, we have to understand a few things about the S&P 500. It is an amalgam of the top 500 companies in the US market. The price that is reflected when the news reports the S&P 500 is a weighted average of all the stock prices and valuations of the companies combined and then averaged. The way Standard & Poor’s comes up with the average price is through a value weighting. This means that they take the number of stocks outstanding from company 1 and then multiply it by the per share price of company 1’s stock and come up with a value for company 1. They do this for all the companies on the list. They then get an average by dividing each company’s value by the total value of all the companies on the list. In this way the more valuable to company, the more weight in the index. For example, Microsoft is currently the most valuable company on the list and it’s relative weighting is almost 6% of the total value of the index. Conversely, Norwegian Cruise Lines is listed at number 492 with a relative weighting of 0.01% of the index total. This means that the change in market price of Microsoft has a dramatically higher affect on the S&P 500 than does Norwegian. In fact, it has an affect on the magnitude of 500 times more. This means that for every $0.01 change to MSFT stock price, NCLH has to move $5 to have the same effect.
Now that we have that, lets look at the top 10 companies on the S&P 500 list.
5. Alphabet Class A
6. Alphabet Class B
7. Johnson & Johnson
8. Berkshire Hathaway Class B
10. Proctor & Gamble
These 10 stocks make up roughly 25% of the value of the S&P 500’s price. So we have 2% of the stocks accounting for 25% of the value. Now here is the chart:
The question then becomes, is this a fair representation of our economy right now? Do these 10 stocks truly make up 25% of our economy? I don’t have the exact answer to that, but if I were made to make a guess right now, I’d say no. I’d say that these companies are actually quite small when we take the American economic machine as a whole. When we consider all the activity that takes place on a daily basis, these companies are but mere cogs, albeit large cogs, in the overall magnitude of our $20.5 Trillion economy.
I’m not trying to be a pessimist about our economy right now, but I found this intriguing and wanted to share my thoughts. I do despise the way our news media reports on the stock market using 3 indexes to “represent” our economy. They routinely report the Dow Jones Industrial Average, the S&P 500, and the NASDAQ average. In my opinion, these indexes are so far from what is actually happening in the ordinary person’s day-to-day life, that it makes no sense to use these measurements as a gauge for true economic activity on Main Street.