Inside The S&P 500 Index: Sectors, Performance, Valuation, And Risk

The S&P 500 Index is one of the oldest and most watched indexes among investors. Launched in 1957, it was introduced by Standard & Poors to track the 500 largest corporations listed on the New York Stock Exchange. Thirty-six years later, in 1993, State Street Global Advisors introduced the first ETF, the Spider S&P 500 (Ticker: SPY), designed to track the index. SPY continues to rank as the largest of all ETFs, with total assets of $278 billion, surpassing another S&P 500 ETF, the iShares Core S&P 500 fund, which has $179 billion.

Before investing in any security it’s important to understand the risks and potential rewards. Here, we will discuss the composition of the index, how each sector within the index has performed, and understand risks associated when investing in it.

S&P 500 Sector Weight Changes

The S&P 500 Index is a market cap weighted index, meaning the largest companies comprise the largest portion of the index. There are 11 different sectors within the index. The following chart shows how the weightings of each sector changed between December 31, 2016 and June 30, 2020. For example, energy stocks, the worst hit during the pandemic, made up 7.56% of the index at the beginning of this period. As of June 30, 2020, energy stocks accounted for only 2.82% of the index. Which sectors increased and which decreased? The largest increase came from technology stocks, which were 20.77% of the S&P 500 at the end of 2016. Because technology stocks performed so well, as of June 30, 2020, they comprised 27.47% of the index. It should be noted that during the 1990s, technology stocks grew from under 10% of the index to over 30% by the end of the decade. While tech stocks today do not comprise as much of the index as they did before the tech bubble burst, they are trending in that direction.

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YTD Performance by Sector

How have the 11 sectors performed during the pandemic? The following chart contains the results as of August 28, 2020. The laggards have been Energy stocks (-40.37%), Financials (-17.98%), and Utilities (-9.40%). Real Estate and Industrials are also in negative territory, but to a lesser extent. Conversely, Technology stocks have been the clear winner, rising 34.04% YTD. Consumer Discretionary (26.81%) and Communication Services (15.24%) have also done well. The remaining sectors with a positive return thus far are Health Care, Materials, and Consumer Staples.

P/E Ratios

One of the stats followed by investors is the P/E Ratio. The ratio is used to determine if a company’s stock price is overvalued or undervalued and is often compared to its historical average. The P/E Ratio reveals the ratio of a company’s share price to its earnings per share. When a company’s share price rises faster than its earnings, the ratio rises. The following chart shows the P/E Ratio for each sector in the index, plus the current and long-term average for the overall S&P 500.

The current P/E Ratio of the S&P 500 is 22.22, which is above its long-term average of 19.4. In fact, the P/E Ratio is higher than the long-term average and the current P/E in 8 of the 11 sectors within the index. Again, when the ratio rises above its long-term average, it is an indication that valuations are rising.

S&P 500 Risks

The greatest risk is the market cap weighted structure. For example, the four largest companies in the index, Apple Inc. AAPL , Microsoft MSFT Corporatio MSFT n, Amazon AMZN .com Inc., and Facebook Inc FB . Class A, collectively, comprise over 20% of the total index. If these companies hit a rough patch, they would cause the index to fall more than if all companies were weighted equally. Of course, this is also true on the upside, as these four giants helped propel the index to its highest level, ever. What if investors suddenly decide that Apple, Microsoft, Amazon, and Facebook are too overvalued and it’s time to take profits? After all, they have had quite a run. In this case, the index would fall much more than if it were, once again, equally weighted.

Does this mean I shouldn’t invest in the index? Not at all. It simply means you should do so with the knowledge that at some point (as experienced when the Tech Bubble burst), the music will stop, stocks will fall, and a market cap weighted index is more prone to a severe decline. Are we close to the top? This is impossible to know, but we are much closer to peak than we were a few short months ago.

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