As the old adage goes, time heals all wounds. The short term financial effect of COVID-19 has been devastating to nearly every investor. The S&P 500 and the Dow Jones both plummeted from their February highs when the global community finally started to understand the full scale of the epidemic.
When the S&P 500 bottomed out on March 23, its value of 2,237.40 represented a 34% drop from its February 19th high. The Dow Jones similarly fell roughly 33% from its YTD high of 29,348.03 on February 19th when it bottomed out on March 23.
Although the Nasdaq, a tech-heavy index, has certainly not been immune from the crisis, its recovery has been much faster than both the S&P 500 and Dow Jones. In mid-April, the Nasdaq witnessed its best week since 2009. Keep in mind that the Nasdaq historically takes longer to recover than other indices.
The Three Major Indices:
In the field of finance and economics, an index measures value. The Consumer Price Index measures the price of goods and services in relation to the average consumer while the GDP Price index measures the rate of inflation with respect to goods and services produced. Similarly, investors use numerous indices like the S&P 500, Dow Jones Industrial Average, and the Nasdaq to gauge market performance.
The S&P 500:
As its name suggests, the S&P 500 measures the stock performance of the 500 largest companies on stock exchanges in the U.S. The S&P 500 is generally considered the best gauge of U.S. stock market performance. This particular index incorporates a market capitalization weighting method that assigns a higher percentage of the index to the highest market-cap companies. At present, the five companies with the largest market-cap make up 18% of the S&P 500.
Market capitalization is calculated by multiplying a company’s share price by the amount of common (public) shares in circulation. For instance, if a company’s stock is selling at $1.00 and it has 10 million common shares in circulation, its market cap would be 10 million – a true nano-cap company. As with other indices, the S&P can easily become inflated. Because mega-cap companies like Apple and Amazon are weighted heavily in the S&P 500, they can have an enormous impact on its price.
The Dow Jones Industrial Average:
Unlike the S&P 500, the Dow Jones only tracks 30 companies that are publicly traded on the New York Stock Exchange and the Nasdaq. Founded in 1882, the Dow Jones is one of the oldest and most analyzed indices in the world.
The 30 companies represented in the Dow Jones are blue-chip stocks with stable earnings, all of which you’ve likely heard of. Over time, some companies have been removed from the Dow Jones if they are viewed as being less representative of the economy or if they are under severe financial distress. The most recent change to the Dow Jones occurred when General Electric was replaced with Walgreens Boots Alliance.
The Dow Jones differs from the S&P 500 because it is typically preferred by retail investors while the S&P 500 is typically preferred by institutional investors. Retail investors are non-professional investors that purchase stocks, bonds, and ETFs through an investment adviser or a brokerage firm.
These investors have a smaller purchasing power because their funds stem from their own personal wealth. Institutional investors comprise 75% of the investors in the U.S. These investors make decisions on behalf of shareholders, mutual funds, pensions, etc.
As the first electronic marketplace, the Nasdaq revolutionized trading when the exchange was introduced in 1971. The index is composed of more than 3,000 influential tech companies like Google and Microsoft. As the technology sector rapidly expanded in the 1980s and 1990s, the Nasdaq followed suit with exponential gains.
The dot-com bubble of the late 1990s peaked in March 2000 before falling 80% by the end of 2002. The Nasdaq’s ingenious technological trading system has been the norm in the modern trading world for decades.
Why Are Index Funds A Safe Bet In The Long Term?
Even a total trading novice will notice a prevalent trend among the three indices described above. A brief glance at their historical value charts shows that although there have been financial catastrophes over the last century that have left noticeable scars, all three continue to trend up. Even though Q1 of 2020 was the worst quarter in the history of the S&P and Dow Jones, there is still a small sense of optimism for the future.
Over the course of the 2008 fiscal year, the S&P 500 lost 37% of its value. This would mean that someone who had invested $10,000 in the S&P would have lost $3,700 for the year, a hefty amount for many investors. But the following year as stimulus money flooded in, the S&P finished up over 26%.
By 2012, that same person would have made their initial investment back and then some. When investors keep enough cash in reserve as a safeguard against a recession/depression, they can wait out the storm. Those who may be over-leveraged in the stock market and cannot afford a sizable investment loss panic and begin to sell-off their positions.
Hedge funds and asset management firms typically face margin calls in terrible economic conditions. A margin call refers to a situation where a broker demands that an investor deposit more money into their account to maintain a minimum amount. Similar to your average retail investor, these firms will sell off a large amount of their assets to maintain the minimum.
Long term investors can take advantage of an economic downturn by purchasing these distressed assets – companies like Valero and Delta who have seen a massive drop in share price – and sell when the economy rebounds and the price of the assets hopefully rise.
We can see the long term increase in value of the major indices below:
Harnessing the Power of Compounding:
Major indices can be used over the long term to make a serious return, but what role does compounding play in how large that return will be? Compounding refers to a technique where earnings from assets and dividends are reinvested. By using this technique, earnings can grow exponentially.
If you invested $10,000 in the S&P 500 in 1970 and did not reinvest earnings, your position would be worth $300,000. If total dividends were reinvested, that same person would have made $1,000,000! Reinvesting dividends supercharges earnings by increasing the amount of dividends a person will receive each time.
If an investor purchases $20,000 of XYZ at a price of $20, they will receive 1,000 shares. If XYZ announces a 50 cent dividend per share, the investor makes $500 in dividends. If that $500 is used to purchase more of XYZ, the future dividend will be higher. The process continues and the account grows exponentially.
When Will The Market Stabilize?
Until the health emergency that COVID-19 has produced is eliminated, panic will continue to run rampant. Although some experts believe jobs will return after the virus is defeated, fear of a second wave in the fall and the loss of thousands of businesses has propelled pessimism. Even as the global community continues to look for answers in the face of the epidemic, long term investors may feel at ease knowing things will look brighter in the future.