The S&P 500 Is Going To Move Much, Much Lower

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How Are S&P 500 Stocks Chosen?

The most important U.S. stock index has some strict — and not-so-strict — rules for companies to get in.

Though the S&P 500 (SNPINDEX:^GSPC) may include only a fraction of publicly traded companies by number, it is undoubtedly the most important index for U.S. stocks.

Together, the roughly 500 companies that make up the S&P 500 comprise more than 80% of the total value of all stocks on U.S. exchanges, making the index a go-to barometer for the performance of domestic stocks.

So how do companies get picked to join this exclusive list? It all boils down to meeting a few rules, and, most importantly, winning the favor of a committee of investors. Here’s how it all works, item by item.

1. Market capitalization is an important filter

The S&P 500 is supposed to represent the largest U.S. companies, so naturally size is an important component. Size, in this case, is determined by the company’s stock market value, or market capitalization, which is the total value of all its shares outstanding.

For example, Coca-Cola has roughly 4.3 billion shares of stock outstanding. As I write this, each share trades for $49. Therefore, its market cap stands at approximately $210 billion.

The cutoff for the S&P 500 moves up and down over time, but the current number to top is $6.1 billion. Of course, 20 years ago, that figure was much lower, and you’d expect that 20 years from now, that number will be much higher.

Image source: Getty Images.

2. Profitability matters. kind of

With few exceptions, companies must be profitable to get into the S&P 500 index. Profitability is measured in two ways: over the last four quarters and in the most recent quarter.

In theory, a company could lose $300 million in each of the first three quarters ($900 million total) and then post a $950 million profit in the final quarter, thus qualifying for the profitability test.

Sum of four quarters

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This is an extreme example to show how the profitability test isn’t particularly demanding, since one quarter of profit could be good enough to meet the criteria. Companies that have recently gone public in an IPO must have at least 12 months of trading history on a large exchange, so a profitable company that goes public can’t immediately hop into the S&P 500 based on its earnings before its IPO.

3. Float and liquidity requirements are easy to check off

The purpose of the S&P 500 is to track large-cap stocks that you can actually invest in. To that end, it has some rules that disqualify companies that are closely held (majority owned by only a few shareholders) as well as companies that are thinly traded (companies whose shares have very little trading volume).

To get into the S&P 500, a company needs to have at least 50% of its stock “floating” on stock exchanges. Logically, it makes sense. A company that is 60% owned by its founder, for example, is arguably more “private” than “public” from an ownership perspective, given that only 40% of shares are in the hands of the investing public.

In addition to being majority owned by the public, a company’s stock must be liquid. Each year, trading volume must exceed 100% of its float, and a minimum of 250,000 shares must trade in the six months leading up to the evaluation date. So if a company has 2 billion shares in the float, at least 2 billion shares must trade hands each year.

Frankly, most large companies check all these boxes without trying. There aren’t many thinly traded, multibillion-dollar companies in which directors, officers, and other major shareholders own more than 50% of the company. And any company that is majority owned by the public will almost certainly pass the test for having ample trading volume.

4. A company must be American enough

The S&P 500 is meant to track large businesses that operate in the United States. To that end, it requires that companies meet some criteria for being U.S. businesses. A company must:

  • File 10-K annual reports with the SEC.
  • Have a “plurality” of assets and revenue in the United States.
  • List on an eligible exchange (basically, any of the large exchanges such as the NYSE or NASDAQ)

There is a lot of wiggle room in these rules. The threshold for having a “plurality” of assets and revenue from the United States is not strictly defined. Companies may register overseas for tax purposes but still be considered U.S. companies for the purposes of getting into the S&P 500.

Perhaps the most strict rule is whether the company is listed on a large U.S. exchange and filing 10-K annual reports. The S&P 500 does not allow any companies that trade over the counter or on the pink sheets to get in.

5. Some companies get a free pass

Stocks that are part of the S&P MidCap 400 and S&P SmallCap 600 can get into the S&P 500 with fewer restrictions. These stocks aren’t subject to rules relating to profitability, float, and/or liquidity. The thinking is that once a company joins any of these indexes, it should be able to move more freely between them.

Acquiring a company in one of these three indexes is an easier way in, as acquirers aren’t subject to rules about profitability or having more than 50% of their shares floating on an exchange.

6. Some companies simply can’t get in

The S&P 500 only includes ordinary corporations and real estate investment trusts (REITs). It excludes some more “exotic” structures, like business development companies (BDCs), master limited partnerships (MLPs), and limited liability companies (LLCs).

Of course, it also excludes closed-end funds (CEFs) and exchange-traded funds (ETFs) for the simple fact they mostly just hold other publicly traded stocks and bonds. Including S&P 500 ETFs in the S&P 500 would be. strange.

Some “normal” corporations are disallowed if they have multiple types of stock. For example, if Berkshire Hathaway weren’t already in the index, it wouldn’t be allowed in because it has Class A and Class B shares with different voting rights. This rule for companies with multiple share classes was put into place right before Snap‘s IPO in 2020, and it has been controversial, to say the least.

Dual-class share structures are extremely common in the technology world, with Alphabet, Square, Facebook, and others having multiple types of shares with different voting rights. Going forward, if a company isn’t already in the S&P 500, having more than one class of stock will keep it out for good.

So far, this rule hasn’t had a truly massive impact on the S&P 500 and its standing against other indexes, but it will almost certainly become more important over time, particularly if an especially large company is excluded from the index because it has a multiclass structure.

7. A committee makes the final decision

Meeting all the basic requirements isn’t enough; companies must get the approval of the index committee to get into the S&P 500, making it more of an “active” index than other indexes that simply use mechanical rules to pick stocks. For example, the Russell 1000 doesn’t have a committee. Either a company meets the mechanical rules or it doesn’t.

The S&P 500 is supposed to be representative of the U.S. stock market. If tech stocks make up 40% of the S&P 500 when they make up 20% of the total value of all U.S. stocks, that’s not ideal. The committee, by adding or removing stocks strategically, can ensure the S&P 500 doesn’t differ meaningfully from the whole market.

A lot of money is invested in funds that track the S&P 500 — Vanguard alone has more than $400 billion of assets in its S&P 500 funds — so it’s important to investors that the index accurately reflects the market.

At times, the committee has taken an active role in “managing” the index’s composition. For example, during the 2008 financial crisis, the U.S. Treasury became a 90% owner of the insurance giant AIG, which would have normally disallowed it from being part of the index. David Blitzer, chairman of the index committee, explained in a blog post that the committee feared that removing AIG might have negatively affected the company and the shaky financial markets, so it kept AIG in the index.

In general, it’s much harder to get kicked out of the S&P 500 than to get in, as S&P Dow Jones Indices explains in its methodology guide:

S&P Dow Jones Indices believes turnover in index membership should be avoided when possible. At times a stock may appear to temporarily violate one or more of the addition criteria. However, the addition criteria are for addition to an index, not for continued membership. As a result, an index constituent that appears to violate criteria for addition to that index is not deleted unless ongoing conditions warrant an index change.

Understandably, adding and removing companies from the S&P 500 is a big deal. With so many funds tracking it, changes can result in huge trading volumes as index funds sell stocks that are removed and purchase stocks that are added. Changes in the index can also trigger capital gains taxes for their investors, which is why many indexes and index funds seek to minimize turnover when possible.

In some way, the people who make up the index committee are some of the most influential people in the financial markets, responsible for decisions that can have billion-dollar consequences for investors.

4 Strategies to Short the S&P 500 Index (SPY)

Since the stock market trends higher or stays level far more often than it declines, it is difficult to make consistent money by shorting stocks or exchange-traded funds (ETFs). Losses on short positions in stocks, ETFs or stock index futures are also potentially unlimited. However, there are times when a bearish bet against a benchmark stock index such as the S&P 500 is appropriate, and there are several methods available.

Key Takeaways

  • Most investors know that owning the S&P 500 index is a good way to diversify your equity holdings since it contains a broad swath of the stock market.
  • But sometimes, investors or traders may want to speculate that the stock market will broadly decline and so will want to take a short position.
  • A short position in the index can be made in several ways, from selling short an S&P 500 ETF to buying put options on the index, to selling futures.

S&P 500 ETFs

By utilizing the SPDR S&P 500 ETF (NYSEARCA: SPY), investors have a straightforward way to bet on a decline in the S&P 500 Index. An investor engages in a short sale by first borrowing the security from the broker with the intent of later buying it back at a lower price and closing out the trade with a profit. The S&P 500 ETF is huge, liquid and closely tracks its S&P 500 benchmark. Hedge funds, mutual funds and retail investors all engage in shorting the ETF either for hedging or to make a direct bet on a possible decline in the S&P 500 Index.

There are also leveraged short ETFs with the objective of returning twice the inverse return of the S&P 500, but be aware they have much more trouble hitting their benchmark. This slippage or drift occurs based on the effects of compounding, sudden excessive volatility and other factors. The longer these ETFs are held, the larger the discrepancy from their target.

Inverse S&P 500 Mutual Funds

Inverse funds seek investment results that match the inverse performance of the S&P 500 Index after fees and expenses. The Rydex and ProFunds mutual fund families have a long and reputable history of providing returns that closely match their benchmark index, but they only purport to hit their benchmark on a daily basis due to slippage.

Similar to the inverse leveraged ETFs, leveraged mutual funds experience a bigger drift from their benchmark target. This is particularly true when a fund leverages up to three times the inverse return of the S&P 500. The Direxion fund family is one of the few employing this type of leverage.

Inverse mutual funds engage in short sales of securities included in the underlying index and employ derivative instruments including futures and options. A big advantage of the inverse mutual fund compared to directly shorting SPY is lower upfront fees. Many of these funds are no-load and investors can avoid brokerage fees by buying directly from the fund and avoiding mutual fund distributors.

S&P 500 Put Options

Another consideration for making a bearish bet on the S&P 500 is buying a put option on the S&P 500 ETF. An investor could also buy puts directly on the S&P 500 Index itself, but there are disadvantages to this, including liquidity. Staying with the ETF is a better bet based on the depth of its strike prices and maturities. In contrast to shorting, a put option gives the right to sell 100 shares of a security at a specified price by a specified date. That specified price is known as the strike price and the specified date as the expiration date. The put buyer expects the S&P 500 ETF to go down in price, and the put gives the investor the right to “put,” or sell, the security to someone else.

In practice, most options are not exercised before expiration and can be closed out at a profit or loss at any time prior to that date. Options are wonderful instruments in many ways. For example, there is a fixed and limited potential loss. Moreover, an option’s leverage reduces the amount of capital to tie up in a bearish position. However, remember the Wall Street aphorism that says the favorite strategy of retail options traders is watching their options expire worthless at expiration. One rule of thumb is, if the amount of premium paid for an option loses half its value, it should be sold because, in all likelihood, it will expire worthless.

S&P 500 Index Futures

A futures contract is an agreement to buy or sell a financial instrument, such as the S&P 500 Index, at a designated future date and at a designated price. As with futures in agriculture, metals, oil and other commodities, an investor is required to only put up a fraction of the S&P 500 contract value. The Chicago Mercantile Exchange (CME) calls this “margin,” but it is unlike the margin in stock trading. There is huge leverage in an S&P 500 futures contract, and a short position in a market that suddenly starts to ascend can quickly lead to large losses and a request from the exchange to provide more capital to keep the position open. It is a mistake to add money to a losing futures position, and investors should have a stop-loss on every trade.

There are two sizes of S&P 500 futures contracts. The most popular is the smaller contract, known as the “E-mini.” It is valued at 50 times the level of the S&P 500 Index. The large contract is valued at 250 times the value of the S&P 500, and volume in the smaller version dwarfs its big brother. Small traders quickly gravitated to the E-mini, but so did hedge funds and other larger speculators, because this contract trades electronically for more hours and with greater liquidity than the large contract. The latter contract still trades on the floor of the CME in the traditional open outcry method. To limit risk, investors can also buy put options on the futures contract rather than shorting it.

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