What is going on with DJIA and S&P 500?

Blog post #459

We believe it is important that you understand how the S&P 500 Index works, the concentration that exists in the technology sector and among the top 5-10 stocks. The S&P 500 has not been this concentrated in any one sector in over 70 years. While the overall Index was up about 5% year to date through July 31, 2020 due to the performance of the top 5 stocks, the remaining 495 stocks were down about (6%) for 2020.

The S&P 500 Index is a widely tracked index, composed of generally the 500 largest public companies which are based in the US. The stocks in the Index change over time, as companies are bought, merge, grow and shrink. A company must be profitable to be added to the Index.

The S&P 500 Index has frequently been concentrated in the past but has become very concentrated in just the technology sector in recent years. The top 5 stocks comprise over 22% of the Index as of July 31, 2020. That is now likely to be 25% or more.  Information technology as a sector is now between 25% – 30% of the S&P 500 Index, as the chart below shows:

 

The S&P 500 is a market-weighted index, meaning that the market value (share price x number of shares outstanding) of the largest companies have the greatest impact on the index’ performance.

As of July 31, 2020, the following are the top S&P 500 stocks and their respective weightings:

 

Apple 6.40%
Microsoft 5.75%
Amazon 4.90%
Facebook 2.26%
Alphabet/Google 3.26% (A and C shares)
Total:
22.57%

 

Apple, Microsoft and Amazon, because of their huge market valuation, have a much, much greater impact on the rise and fall of the Index than other companies. Apple’s price change has almost 6X greater impact than Visa, the 10th largest stock, (1.18% as of 7/31/20).

Two examples of large companies, but with much less impact on the Index’ performance would be:

  • Netflix, 22nd largest, but only a 0.781% weighting
  • Costco, 41st largest, but only a 0.522% weighting (as of 6/30/20).

It is widely believed that Tesla will be added to the S&P 500 in the near future. This may have a dramatic impact on the performance of the S&P 500 Index. To be eligible to be added to the S&P 500, a company must be profitable for four straight quarters. Tesla this reached profitability as of June 30th, primarily due to the sale of energy credits, not its core car making business.

Tesla has a market valuation of $400 billion, which exceeds that of Walmart, which is valued at $370 billion. It is rare that a company with a market cap as high as Tesla would initially be added to the S&P 500. Normally, a company with such a massive market cap would have been profitable much earlier and added to the Index before it became so large.

One measure of a company’s relative price valuation is called the P/E ratio, or Price/Earnings ratio. Generally, the higher the number, the more future growth is expected. A very high PE ratio is also viewed as a sign of greater risk. The overall S&P 500 Index currently has a PE ratio of around 24.Tesla currently has a PE ratio of greater than 1,100. Walmart has a PE ratio of 21. 

If Tesla is added to the S&P 500, it would be in the top 10-15 stocks. Tesla’s market cap of $400 billion would be just below the $461 billion market valuation of Visa (both values as of 8/26/20), which is the 10th largest company as of 7/31/20, at 1.18% of the Index. Thus, Tesla would carry a lot of weight in the Index, and it has been a very volatile stock. Tesla has experienced an incredible rise since June 2019. It has also had other periods of huge and fast declines. If it is added to the S&P 500 Index, Tesla would likely add a lot of volatility to this widely tracked index. 

I wrote a post in January 2018, explaining that only 5 stocks caused over 50% of the 2017 DJIA increase (Boeing, Caterpillar, UnitedHealth Group, 3M Co and The Home Depot). Please see this post, 5,000, 30, 5 and 2, for further information. The impact of the top 5 stocks on the S&P 500 Index and this example of the DJIA are why we stress that our broadly diversified portfolios will often act differently than these major market indices. We believe that broad diversification, and not just holding large growth companies, are important in the long-term.

Our goal for nearly all of our clients is to help you reach your financial goals, while taking an appropriate manner of risk. Thus, we feel it is in your best financial interest to own the S&P 500, but only as a portion of your overall portfolio. Historically, over the long term, a globally diversified portfolio has outperformed the S&P 500. This will certainly not be the case every year, or possibly for years at a time. And that is why investing requires discipline and an understanding of how markets and indices work.

Major impact: It is important to note that over $11 trillion dollars track the S&P 500 Index as of the end of 2019. Thus, changes to its composition and the weightings of the top stocks have major market impacts. While the DJIA is widely cited by the press, only about $31 billion in assets actually track the Dow, so the changes discussed below don’t lead to an immediate shift in investor behavior.

Apple stock split causing changes to the Dow

The Dow Jones Industrial Average (DJIA) is quite different than the S&P 500. The DJIA consists of only 30 stocks. The DJIA index is calculated in an unusual method, which emphasizes the actual price change of the highest priced stocks in the index. The Dow is a price-weighted index, meaning higher-priced stocks contribute more points to the index’s daily moves. It is not based on the percentage change of each company and the companies are not equally weighted. 

Apple stock is around $500 per share. Apple is currently the highest price stock of the 30 Dow components, meaning that Apple’s price changes exert the most influence on the DJIA. However, next Monday Apple stock is being split of 4 to 1. This means that each Apple shareholder will receive 3 additional shares and the price will drop to around $125 per share, if the price does not change.

Thus, because of its price per share reduction, Apple will go from being the largest DJIA influencer to middle of the pack, as its approximate $125 share price would be in the middle of the 30 stocks in the Dow. The stock split will have no impact on Apple’s large influence on the S&P 500 Index, as the market capitalization of Apple is not affected by the stock split. United Health Group ($308 per share) will now be the highest price stock in the Dow, and its biggest influencer.

As a result of the Apple stock split, and the change to Apple’s stock price, Dow Jones is adding and deleting stocks to the DJIA, and will modify the divisor that it uses to calculate the DJIA, effective Monday August 31. The changes and prices of each, as of end of business day, 8/26/20:

Being Added to DJIA:

Salesforce.com $272 (increase from $216 a few days ago), technology
Amgen $250, biopharmaceutical
Honeywell $165, industrial

Being Deleted to DJIA:

Exxon $40, energy
Pfizer $38, pharmaceutical
Raytheon Technologies $61, defense and industrial

S&P Dow Jones Indices, which manages the benchmark, is adding Salesforce to add another technology component, as Apple’s influence will be less in the future. They are swapping two large pharmaceutical companies, likely to get a faster growing company and one with a higher price, in Amgen. Each company being added have high stock prices, so each will have significant impact on its daily movements.  Actually, each newly added company will have more influence on the Dow than Apple will, for now.

Deleting Exxon from the DJIA tracks the reduction of the energy sector in the broader economy. Exxon was the longest lasting member of the DJIA, first added in 1928. This leaves Chevron as the only energy company in the Dow, with just 2.1% of the price-weighted index. At the end of 2011, energy was 12% of the S&P 500. Energy is now only about 2.5% of the S&P 500, the smallest of the 11 industry sectors. Exxon and Raytheon were down at least 30% on the year, so this is a way to potentially add “better performers” to the DJIA.

The Dow and S&P 500 Index, though very different based on composition, number of components and how each is calculated, have behaved similarly over long periods of time. This year has been different, as the S&P 500 was up over 6% for the year as of a few days ago, while the DJIA was down about (1%) for 2020.

We feel that one of our roles is to provide you with helpful and timely information, so you can understand certain financial matters. As the S&P 500 Index and DJIA are mentioned in the press often, we thought this explanation would be beneficial, as well as inform you how concentrated the S&P 500 is in just a handful of technology stocks.

 

Sources:
1. “Salesforce, Amgen, Honeywell to Join Dow Jones Industrial Average“, The Wall Street Journal, by: Michael Wursthorn, August 24, 2020
2. “Exxon’s Departure From Dow Highlights Market’s Retreat From Energy Bets“, The Wall Street Journal, by: Karen Langley, August 25, 2020
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