Indexology^® Blog

Despite the hovering cloud of geopolitical menace as we entered 2019, the U.S. equity market enjoyed an almost seamless rise through the first four months of the year. May’s retreat reacquainted investors with volatility and served as a reminder that the market is near all-time highs, having enjoyed a more or less sustained increase for 10+ years, and that any number of unpredictable circumstances could adversely affect the economy.  Should investors accordingly reduce equity exposure?

Three years ago we introduced the dispersion-correlation map as a guide to understanding market dynamics.  Exhibit 1 graphs each year’s average dispersion and correlation, along with the year’s total return for the S&P 500.  Dispersion, as the graph shows, tends to cluster in the neighborhood of 20%.  The exceptions to this rule are typically years of dramatic market action, including such meltdown years as 2000-03 or 2008.  In our (admittedly limited) data history, very high dispersion has been a necessary, but not sufficient, condition for very bad markets.  For the 12 months ended May 31, 2019, dispersion crept slightly higher than its long term median but is well below “very high” territory.

EXHIBIT 1: DISPERSION-CORRELATION MAPS (RETURNS)

All of the data in Exhibit 1 are 12-month averages.  Shifting to one-month data, Exhibit 2 compares May 2019 to the 24 months of two notably-bad years, 2001 and 2008.  The conclusion is the same – today’s dispersion level is well below those typically found in market meltdowns.

EXHIBIT 2: S&P 500 MONTHLY DISPERSION & CORRELATION

Last month, in collaboration with S&P Dow Jones Indices (S&P DJI), LinkUp launched the S&P 500® LinkUp Jobs Index and related sector indices. The Index measures labor demand for companies within the S&P 500 at an aggregate, sector, and individual company level and serves as an indicator of the health of the labor market and economy as a whole.

Because the Index is constructed from job openings in LinkUp’s job search engine that are sourced directly from corporate websites daily, it provides real-time insight into the labor demand of the 500 companies and their subsidiaries in the S&P 500. Using the Index and data behind it, Molly Moseley of LinkUp explored the recently announced Ford Layoffs in relation to the consumer discretionary sector as a whole. You can view more about the launch of the Index here. 

Discretionary spending is up in 2019. However, while people might be buying plenty of things, it appears cars aren’t on their must-have-it-now list.

Slow Q1 sales have been commonplace for major automotive retailers since 2016.  (See below chart.) As sales lag, it’s interesting that Ford just announced it will be laying off 7,000 people by the end of August. Most of the reductions are expected overseas, with an estimated 2,300 layoffs in the United States impacting mostly managers and other salaried employees, not hourly factory workers. Ford had similar layoffs almost exactly two years ago in an effort to reduce costs and run leaner overall.

Large layoffs like these can typically be seen in job opening data. Companies often remove job openings from their website and off their “books” in order to meet layoff goals. The graph below shows Ford’s job openings in relation to fellow automaker GM, in the context of the S&P 500® LinkUp Jobs Consumer Discretionary (Sector) Index in which it falls, within the S&P 500 LinkUp Jobs Index. You’ll see that while the S&P 500 LinkUp Jobs Consumer Discretionary Index from 2016 to date is up overall (gray line), job listings at Ford and GM are down (dotted lines).

If we look at Ford data specifically, it can provide interesting insights into the current scenario. In the below graph, Ford job openings are broken out by occupation. You can see that management positions (blue) decreased mid-2017 due to the layoffs two years ago. It will be interesting to see if the same decrease in management positions will occur this year due to the new announcements.

This close look at management positions over time makes it even easier to see the dramatic dip in 2017. Keep in mind, layoffs were announced in May that year.

Job listings data may provide insight into the health of a company today and what may be just around the corner.

After four consecutive months of gains by the S&P 500^®, the U.S. equity market broadly declined in May. The S&P 500, S&P MidCap 400^®, and S&P SmallCap 600^® declined 6.6%, 8.1%, and 8.9%, respectively. The primary catalyst was the renewed trade tension between the U.S. and China, which reversed course from the optimism coming out of March and April negotiations. On May 10, 2019, President Trump followed through on earlier threats to increase tariffs to 25% on USD 200 billion of Chinese products. This move was promptly thereafter reciprocated with tariffs raised on USD 60 billion of U.S. goods, effective June 1, 2019. Investors were left mulling the short- and long-term effects this would have on the global economy.

Large-cap Real Estate was the only segment of the U.S. equity market to post a gain in May. The 41 other U.S. equity segments were negative. The S&P 500 Real Estate finished May up 0.9%. The Real Estate sector consists of real estate investment trusts (REITs) and real estate management and development companies. The sector benefited in May from its relatively low exposure to foreign markets. Utilities, which was the best performer in May within the mid- and small-cap segments, was the only sector with lower average foreign revenue exposure than Real Estate. The Energy sector had the worst returns across all three size segments.

As of May 31, 2019, the Real Estate sector was the top-performing sector year-to-date. The price return of S&P 500 Real Estate year-to-date was 17%. The S&P 500 as a whole returned 9.8%. With strong price performance and an index dividend yield well above 3%, large-cap Real Estate was a clear winner through the first five months of 2019.

May 2019 marked the 11^th time since January 2009 that the U.S. equity market declined this broadly. In the 10 previous instances when only 1 or 0 of the segments across U.S. equities were positive for the month, the S&P 500 average return was -5.6%. Only twice did the S&P 500 fully recover in the immediately following month, although the index had a positive return for 6 out of 10, averaging 1.9%, with a maximum increase of 10.8% and decrease of 11.0% (see Exhibit 3).

This is more an eyewitness account than an analytical review of the growth of indexing since I joined S&P in 1982.

The growth in indexing in the 20 years from S&P 500 futures in 1982 to the bottom of the tech bear market in 2002 was just a warm up. Two trends encouraging index growth reached critical mass in the 2000s: ETFs with low fees and attractive performance combined with the rise of discount brokerage. Discount brokerage began in 1975 when fixed commission rates ended. The earliest online brokers dated from 1991. In the aftermath of the tech bust investors were concerned about fees, wanted transparency and diversification – demands that ETFs and discount brokerage could meet.

The number and variety of indices broadened as well.  The S&P Midcap 400 and S&P Small Cap 600 joined the S&P 500 in the 1990s. Reaching beyond the home market, S&P adding the IFC emerging market indices in 1997. Next came exchange agreements in Canada and Australia in 1998 and 2000 and the BMI global equity indices in 2003.

In 1999, S&P and MSCI developed the Global Industry Classification Standard (GICS) to give investors a consistent way to categorize companies into sectors and industries.  With GICS, an analyst following the S&P 500 could know how much the market rose and what industries or sectors drove the gains. Using indices defined by GICS, she could choose which sector to invest in or how to re-weight the sectors in the S&P 500.

Indexing was never limited to equities and stock markets. S&P’s first bond indices designed to support ETFs were introduced in 2000 covering municipal bonds. In 2006, S&P began working with Robert Shiller, Yale economics professor, to publish indices on home prices in selected cities around the US. The indices, now known as the S&P Corelogic Case-Shiller Home Price Indices, became a key benchmark of home values during the financial crisis.  A year later in 2007 S&P acquired a leading commodity futures index, S&P GSCI, from Goldman Sachs.

The Global Financial Crisis and Great Recession of 2007-2009 gave us the second 50% bear market this century.  The S&P 500 fell 56.8% from October 9, 2007 to March 9, 2009. In the aftermath of a bear market some promise never to invest in stocks again, others look for new ways to build an index.

Factor indices were one new way. Rather than select stocks by size or sector, factor indices identify factors that affect stock performance and design indices which include desirable factors. One factor index introduced in response to the bear market and the financial crisis was the S&P 500 Low Volatility Index. As the name suggested, it is intended to be less volatile – maybe less worrisome – than the S&P 500.  Many others followed.

With the development of factor indices, index providers mounted a new challenge to active management and stock picking.  The initial thrust of indices was tracking the entire market with minimal expense. Investors benefited because few managers seemed to consistently pick the right stocks. The goal of factor indices is two-fold: adopt strategies based on the same academic research active managers follow combined with the lower expense structures of ETFs tracking indices. Many indices S&P DJI introduces today build on factors and similar strategies.

A major event for both S&P Indices and Dow Jones Indexes was joining two major index groups in 2012. Together they became S&P Dow Jones Indices bringing the two best-known equity indices – the Dow Jones Industrial Average and the S&P 500 – into the same organization. The DJIA traces its history back to 1896 and a predecessor index to 1884.  The S&P 500 became 500 stocks in 1957 when it was developed from an earlier index, the Standard Statistics 90 Stock Index that started in 1926.

The market has changed a lot since S&P 500 futures started. The number of listed equities in the US peaked in 1997 at about 7500; today there are slightly less than 4000 stocks.  The recent corporate tax cuts may encourage some limited partnerships to convert to C-corporations adding some larger names to the market. Due to the tech booms of the 1990s and the last ten years, some of the names at the top of the S&P 500 are relatively youthful and joined the index recently: Google joined the index in 2006, Amazon in 2005 and Facebook in 2012. Two older tech names are Microsoft added to the S&P 500 in 1994 and Apple added in 1982. Berkshire Hathaway joined in 2009 when it acquired Burlington Northern and split its class B stock. Currently the five biggest names in the S&P 500 do not include any banks or oil companies.

Estimates of the percentage of the US equities in index portfolios, funds and ETFs vary from 15% to almost 50%.  Indexing is here to stay and is likely to grow further.  We will never see a time when the whole market is indexed. More importantly, as indices based on factors, sectors, ESG requirements and other approaches join float adjusted market cap indices there will be no less diversity in the market. One factor index will rebalance out of a stock while another rebalances into the same stock.

Part 1 covered the period from 1982 to 2002

This is more an eyewitness account than an analytical review of the growth of indexing since I joined S&P in 1982.

At the beginning of 1982, few people saw indices as a business. There were only two well-known US indices – the S&P 500® and the Dow™ – and one index fund. Interest rates and inflation were in double digits and the economy was in the second of two back-to-back recessions. No one wanted to buy stocks.

That January the Chicago Mercantile Exchange (CME) began trading futures on the S&P 500. In August the Fed backed away from tight money, T-bills fell under 10% and bull markets in stocks and bonds began. Stocks didn’t peak until 2000, after a nasty moment in October 1987. Bonds may not have peaked yet. By the end of 1982 Wall Street was using the S&P 500 futures to hedge positions and indices weren’t just for promoting newspapers. In 1983, the Chicago Board Options Exchange (CBOE) began trading options on the CBOE 100 stock index under the ticker OEX, later the index became the S&P 100.

Indices were a small part of S&P. In 1983, there were about 10 people in the index group when its name was changed to Index Services from Research. Today “the S&P” means the S&P 500. In 1983, the initials meant S&P Stock Reports – one page stock recommendations.  S&P had many more people supporting active managers and stock pickers than working on indices.

Black Monday was October 19, 1987, the day the market crashed. From January to late August 1987, the market rose 37%; from the high to October 16, it dropped 16%. On Monday, October 19, the S&P 500 lost 20%. The Dow lost 22%. Then it recovered: The S&P 500 closed 1987 unchanged for the year.  The one-day drop on October 19 was greater than the crash of 1929, which took two days.

In 1980s, trading stocks became an American pastime and part of daytime television with Financial News Network, acquired by CNBC in 1991. The S&P 500 became the benchmark and scorekeeper for the markets. Investment banks hired analysts to track indices and companies started asking how to become part of the S&P 500.

The 1990s started with a recession as the market that fell 23% from July to October 1990.  At the American Stock Exchange (later acquire by the NYSE) the new products team, looking for ways to increase trading volume, dug into the SEC’s report on the 1987 crash. Buried in the report was a comment that a mechanism to execute a single trade for a basket of stocks or an index would have helped. From that thought came the “Big SPDR” – the first US exchange traded fund (ETF) launched in 1993.  The ETF tracked the S&P 500; SPDR stood for Standard & Poor’s Depository Receipts.

The ETF brought several innovations to investors: It could be bought and sold through any broker and traded any time the market was open. ETF fees are typically lower than actively managed mutual funds.  ETFs are designed to track an index and the index gives investors transparency into strategy and securities.

The Tech bull market that began in 1995 put indices on the map. Most tales of the tech boom-bust chronicle the insanity of the boom exemplified by Pets.com (a real company). There were other, more substantial companies, pushing the market higher.  Two internet pioneers, which met the S&P 500 requirement for positive earnings, were added to the S&P 500: America Online (AOL) in December 1998 and Yahoo in December 1999.  Both are now part of Verizon.

The bull market paused in 1998 when Russia defaulted of its debt in August and Long Term Capital Management, an aggressive hedge fund, collapsed in September. Stocks dropped 19% before rebounding. The end of the Technology bull market came on March 24, 2000. From then until October 9, 2002 the market fell 50%.

The Tech bust had a lesson for investors. Weighting an index by companies’ market caps is a natural approach – the market itself is cap weighted so the index return and the market return should match. The Tech Boom-Bust proved that on the way up cap weighting can be a strong momentum performer. On the way down after the market turns, the index is often over-weighted in the stocks with the most to lose.  S&P began exploring other ways to weight indices.

In January 2003, S&P launched an equal weighted version of the S&P 500. Rather than weighting stocks by market value, the index weights each stock equally. Compared to the standard S&P 500, the equal weight version over weights the smaller stocks and under weights the larger ones. From January 2003 to May 2019, the equal weight S&P 500 returned 9.2% per year compared to 7.3% per year for the cap-weighted version.

The weighting in the standard S&P 500 shifted to float adjusted market capitalization in 2005. With the increasingly popularity of indices, investors recognized that excluding closely held shares which rarely trade would make tracking an index with an ETF easier. The average float among S&P 500 stocks was over 90% and the index had always excluded stocks with a float less than 50%, so there was not a major impact from float adjustment.

See Part 2 on the time since the Tech Bust.