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

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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). You can sell short S&P 500 ETFs like SPY, but this strategy can be risky since losses on short positions in stocks, ETFs or stock index futures are potentially unlimited, and may be subject to margin calls. 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 reasonable 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.

Inverse 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.

But if you don’t want to sell the ETF short, you can instead go long (i.e. buy) an inverse ETF that goes up when the underlying index goes down. For example SPDN is the Direxion Daily S&P 500 Bear ETF that is designed to provide 1x inverse exposure to one of the most popular indexes among investors.

There are also several leveraged short ETFs with the objective of returning twice or 3x 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 mutual funds, known as bear funds, also 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.

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.

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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The Bottom Line

When bear markets arrive, shorting individual stocks can be risky and hard the best stocks to short hard to identify. Just as owning the S&P 500 index in a bull market provides less volatility and diversification, shorting the index during a bear market can provide similar benefits to a bearish investor. Here, we go over some effective ways of gaining short exposure to the index without having to short stocks.

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

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.

Here’s How Much The S&P 500 Needs To Fall To Match The ‘Great Recession’

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A trader works on the floor of the NYSE on Tuesday, Feb. 6, 2020. U.S. stocks are up half a percent . [+] on Feb. 12 after a rough week that saw the Dow lose over 2,000 points. Photographer: Michael Nagle/Bloomberg

The contrarians love a good chart-to-hell.

The S&P would have to lose over 1,000 points to reach ‘Great Recession’ levels. The stock market has . [+] been on a tear thanks to central bank stimulus and a low Federal funds rate.

After the Great Recession of 2008-09, when famous investment banks evaporated along with the deeds to homes for hundreds of thousands of Americans, the S&P 500 got a shot in the arm. It was a one-two punch of falling interest rates and a Federal Reserve buying up once-toxic mortgage-backed securities. The Fed helped prop up the bond market too, keeping rates in constant decline. Equities were the only place to make money. Bonds were treated like stocks, with fixed income investors giving up on yield and just hoping a bond priced at 101 can one day hit 120. Everything was sky high. That was the story for about nine years.

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Newspapers from October 1987. Markets crash. They take years to recover. Is this market going to be . [+] the next bear for the history books? (AP Photo, file)

But if you believe that once the central banks give up on QE, and once interest rates “normalize,” that the equity market retreats to pre-QE levels, then you would likely think the S&P 500 goes to around 1500 points.

Prior to 2008-09, the previous bear market occurred when the dot-com bubble burst and two American Airline jets piloted by terrorists slammed into the Twin Towers in lower Manhattan on Sept. 11, 2001. The S&P 500 fell 49% from a high of around 1510. It took six years to recover before falling again, this time to 666 in intraday trading on March 6, 2009. It was the lowest the S&P 500 had seen since 1996.

The reason for last week’s equity market slide can be traced to the U.S. non-farm payroll report for January, which featured an increase in average earnings growth to 2.9%, the fastest rate since 2009.

Wage inflation spooked the bond markets. The prospect of higher inflation also resulted in the markets pricing in a 0.75% rate hike this year, with the probability of a fourth hike increasing.

The so-called “Powell Put” is thought to be less market-friendly than the “Greenspan-Bernanke-Yellen Put,” which helped push equity valuations to record levels and inflated financial asset prices in general.

The VIX trades spiked more than during the Brexit vote. Investors now believe the volatility trade . [+] is what crushed the Dow.

Inflation concerns were exacerbated by the unraveling of strategies betting on low equity volatility through ETNs , exchange-traded notes. The rout was partly triggered by the quick run-up in government bond yields, but investors who want to remain upbeat just need to focus on the economic fundamentals, says BlackRock’s chief investment strategist Richard Turnill in his recent market commentary.

Those fundamentals might be changing, by Turnill’s own admission.

A budget deal approved by Congress last week will significantly increase government spending on defense and other items by roughly $300 billion over two years. The big spending bill, together with tax cuts, will widen the federal deficit.

“We could see net Treasury coupon issuance more than doubling this year,” he says.

Bad for U.S. Treasury bonds. The bond market is bigger than the equity market.

Turnill estimates that the combined effect of government spending and corporate tax cuts could add roughly 1% to GDP this year, compared to the 0.8 percentage point they forecast in his last outlook report.

The stronger economy could easily raise inflation expectations and cause the Fed to hike interest rates faster, and that, with central banks unwinding their QE programs, could drive the S&P much lower than it is today. If the bears finally get their day in the sun.

The S&P 500 and How It Works

How the S&P 500 Tells You About America’s Health

The S&P 500 is a stock market index that tracks the stocks of 500 large-cap U.S. companies. It represents the stock market’s performance by reporting the risks and returns of the biggest companies. Investors use it as the benchmark of the overall market, to which all other investments are compared.

As of March 13, 2020, the S&P 500 has an average 10-year annual return of 7.99%.   S&P stands for Standard and Poor, the names of the two founding financial companies.

The S&P 500 was officially introduced on March 4, 1957, by Standard & Poor. McGraw-Hill acquired it in 1966. The S&P Dow Jones Indices owns it now and that’s a joint venture between S&P Global (formerly) McGraw Hill Financial, CME Group, and News Corp, the owner of Dow Jones. 

How the S&P 500 Works

The S&P 500 tracks the market capitalization of the companies in its index. Market cap is the total value of all shares of stock a company has issued. It’s calculated by multiplying the number of shares issued by the stock price. A company that has a market cap of $100 billion receives 10 times the representation as a company whose market cap is $10 billion. As of February 2020, the total market cap of the S&P 500 is $24.4 trillion.   It captures 80% of the market cap of the stock market.

The index is weighted by a float-adjusted market cap. It only measures the shares available to the public. It does not count those held by control groups, other companies, or government agencies.

A committee selects each of the index’s 500 corporations based on their liquidity, size, and industry. It rebalances the index quarterly, in March, June, September, and December. To qualify for the index, a company must be in the United States, have an unadjusted market cap of at least $8.2 billion. At least 50% of the corporation’s stock must be available to the public. Its stock price must be at least $1 per share. It must file a 10-K annual report. At least 50% of its fixed assets and revenues must be in the United States. Finally, it must have at least four consecutive quarters of positive earnings.

The stock can’t be listed on pink sheets or traded over the counter. It must be listed on the New York Stock Exchange, Investors Exchange, Nasdaq, or BATS Global Markets. 

As of March 13, 2020, the 10 largest companies, with a weighted market cap, in the S&P 500 were:

  1. Microsoft Corp.
  2. Apple Inc.
  3. Amazon.com Inc.
  4. Facebook Inc. A
  5. Berkshire Hathaway B
  6. Alphabet Inc. A (GOOGL)
  7. Alphabet Inc. C (GOOG)
  8. JP Morgan Chase & Co.
  9. Johnson & Johnson
  10. Visa Inc. A

The makeup of the S&P 500 industries reflects that of the economy.

As of March 13, 2020, the S&P 500 sector breakdown includes:

  • Information Technology: 24.4%
  • Health Care: 14%
  • Financials: 12.2%
  • Communication Services: 10.7%
  • Consumer Discretionary: 9.9%
  • Industrials: 8.9%
  • Consumer Staples: 7.2%
  • Energy: 3.6%
  • Utilities: 3.5%
  • Real Estate: 3.1%
  • Materials: 2.5% 

S&P 500 vs. Other Stock Market Indexes

The S&P 500 has more large-cap stocks than the Dow Jones Industrial Average. The Dow tracks the share price of 30 companies that best represent their industries. Its market capitalization accounts for almost one-quarter of the U.S. stock market. The Dow is the most quoted market indicator in the world. 

The S&P 500 has fewer technology-related stocks than the Nasdaq. As of June 28, 2020, 55% of Nasdaq allocations are in information technology compared to 24.4% for the S&P 500.   The Nasdaq also includes the stocks of companies that are privately-owned.

Despite these differences, all these stock indexes tend to move together. If you only focus on one, you will still be able to understand how well the stock market is generally doing. In other words, you don’t have to follow all three.

Milestones of the S&P 500

The following table shows various milestone events of the S&P 500, including both highs and lows, and other memorable moments. 

Date Close Event
Jan. 3, 1950 16.66 Record closing low, first close
June 4, 1968 100.38 First time above 100
Oct. 19, 1987 224.84 Black Monday
March 24, 1995 500.97 First close above 500
Feb. 2, 1998 1,001.27 First close above 1,000
Oct. 9, 2007 1,565.15 Highest close before financial crisis
Oct. 13, 2008 1,003.35 Largest % gain of 11.6%
March 28, 2020 1,569.19 New record high
Aug. 26, 2020 2,000.02 First close above 2,000
Sept. 21, 2020 2,929.67 New record high
Oct. 3, 2020 2,937.06 Highest intra-day
July 12, 2020 3,013.77 First close above 3,000
Feb. 19, 2020 3,393.52 New record high
March 12, 2020 2,480.64 Largest % decline since Black Monday, entered bear market

How to Use the S&P 500 to Make Money

Although you can’t invest in the S&P, you can mimic its performance with an index fund. You could also buy shares of stocks that are in the S&P 500.

Be sure to weigh the stocks in your portfolio according to their market cap, as the S&P does.

You should use the S&P 500 as a leading economic indicator of how well the U.S. economy is doing. If investors are confident in the economy, they will buy stocks.

Since the S&P 500 only measures U.S. stocks, you should also monitor foreign markets. That includes emerging markets like China and India. It may also be a good idea to keep 10% of your investments in commodities, like gold. They tend to hold value longer when stock prices drop.

Besides following the S&P 500, you should also follow the bond market. Standard & Poor’s also gives bonds credit ratings. When stock prices go up, bond prices go down. There are many different types of bonds. They include Treasury bonds, corporate bonds, and municipal bonds. Bonds provide some of the liquidity that keeps the U.S. economy lubricated. Their most important effect is on mortgage interest rates. 

The Bottom Line

Although the Dow is the most popularly known index, investors usually look to the S&P 500 when assessing how the overall stock market is doing. As such, this index is considered a leading U.S. economic indicator.

It tracks 500 publicly traded, large-cap U.S. companies. These businesses must meet specific criteria in order to be a part of the S&P 500. The mix of industries that make up the S&P 500 list often reflects the economic makeup of the United States.

Investors can purchase shares of stocks listed on the S&P 500 or invest in index funds that track the S&P 500.

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