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Thoughts On S&P 500 Earnings, Valuation And Returns

By Ed YardeniStock MarketsNov 22, 2020 11:51PM ET
www.investing.com/analysis/thoughts-on-sp-500-earnings-and-valuation-200545457
Thoughts On S&P 500 Earnings, Valuation And Returns
By Ed Yardeni   |  Nov 22, 2020 11:51PM ET
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The following is the Introduction to our latest study in our "Predicting the Markets" series. The paperback and e-book are available on Amazon here. The other studies in this series are available on my Amazon author's page here.

I started my career on Wall Street in 1978. I spent the prior year at the Federal Reserve Bank of New York in the economics research department after receiving my undergraduate degree in economics and government from Cornell University in 1972 and my PhD in economics from Yale University in 1976. Over the past 40-plus years, I’ve worked as both the chief economist and the chief investment strategist at several firms on Wall Street. Since January 2007, I’ve been the president of my own consulting firm, Yardeni Research, Inc.

My job continues to be to predict the financial markets, particularly the major stock, bond, commodity, and foreign exchange markets around the world. I’ve learned a lot about these markets over the years. I recently started sharing what I’ve learned in a series of books and studies.

In this study, I will focus on the S&P 500 stock price index, examining how it is determined by the earnings of the 500 companies that are included in the index and the valuation of those earnings by the stock market.

Why pick the S&P 500?

The S&P 500 is a stock market index that measures the stock price performance of 500 large companies listed on stock exchanges in the United States. It is one of the most widely followed equity indexes. The stocks in this index are a representative sample of leading companies in leading industries. Many equity managers benchmark the performance of their portfolios to the S&P 500. Among the largest exchange-traded funds are those that track the S&P 500. The S&P 500 represents more than 83% of the total domestic US equity market capitalization.[1]

The widely followed Dow Jones Industrials Average (DJIA) has only 30 companies. It was launched in 1896 and was a spin-off of the Dow Jones Transportation Average, which was first compiled in 1884 by Charles Dow, the co-founder of Dow Jones & Company. The S&P 500 dates back to 1923. That year, the Standard Statistics Company (founded in 1906 as the “Standard Statistics Bureau”) developed its first stock market index, consisting of the stocks of 233 US companies and 26 industries, computed weekly. (The company also began rating mortgage bonds in 1923.) In 1926, it developed a 90-stock index, computed daily. In 1941, Poor’s Publishing merged with Standard Statistics Company to form Standard & Poor’s (S&P). On March 4, 1957, the index was expanded to its current 500 companies and was renamed the “S&P 500 Stock Composite Index.”

The components of the S&P 500 index and other S&P indexes are selected by the firm’s US Index Committee, which meets monthly. All committee members are full-time professional members of the firm’s Indices staff. At each meeting, committee members review pending corporate actions that may affect the indexes’ constituent companies, statistics comparing the indexes’ composition to the broad stock market, candidate companies under consideration for addition to an index, and the bearing of any significant market events on the indexes.

The committee identifies important industries within the US equity market, approximates the relative weight of these industries in terms of market capitalization, and then allocates a representative sample of stocks within each industry of the S&P 500. There are 11 sectors according to the Global Industry Classification Standard (GICS): Communication Services, Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Real Estate, and Utilities.[2] These sectors are further divided into 24 industry groups, 69 industries, and 158 subindustries.

Candidates for inclusion in the S&P 500 index must meet specific criteria in eight areas: market capitalization, liquidity, domicile, public float, GICS, financial viability, length of time publicly traded, and stock exchange listing. The index is reconstituted quarterly, though changes are made infrequently.

The S&P 500 index is a free-float, capitalization-weighted index. That means that companies are weighted in the index in proportion to their market capitalizations. To determine the market-capitalization weight of a company, only the number of shares available for public trading (free float) is used. Shares held by insiders or by controlling shareholders that are not publicly traded are excluded from the calculation. The largest companies (based on market capitalization) in the S&P 500 account for a substantial portion of its total market capitalization. Since the index is market-capitalization weighted, these companies have the greatest influence on the index’s price performance.

Notwithstanding occasional bear markets, the S&P 500 has been a great investment over the years—so much so that “S&P” could stand for “Success & Profit.” Since January 1, 1955, through September 2, 2020, the index has been down in bear markets during 3,029 of the 16,535 trading days—i.e., just 18.3% of the time. It has risen at a compounded annual rate of 6%, a rate that doubles the value of this portfolio every 12 years. And that doesn’t include the dividend return provided by many of the S&P 500 companies.

The first chapter in our study covers the various measures of earnings for the S&P 500 and why we favor forward earnings among them. The second chapter discusses various models of valuation, again focusing on the S&P 500. The final chapter uses the resulting analytical framework to review how it has worked in good times and bad, focusing on the Great Financial Crisis and the Great Virus Crisis.

[1] See S&P Global, S&P 500: The Gauge of the Market Economy and S&P U.S. Indices Methodology, August 2020. See S&P Dow Jones Indices.

[2] The Global Industry Classification Standard is jointly developed and maintained by S&P Dow Jones Indices and MSCI.

Thoughts On S&P 500 Earnings, Valuation And Returns
 

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Thoughts On S&P 500 Earnings, Valuation And Returns

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