A stock index simply represents a basket of underlying stocks. Indices can be either price-weighted or capitalization-weighted. In a price-weighted index, such as the Dow Jones Industrial Average, the individual stock prices are simply added up and then divided by a divisor, meaning that stocks with higher prices have a higher weighting in the index value. In a capitalization-weighted index, such as the Standard and Poor's 500 index, the weighting of each stock corresponds to the size of the company as determined by its capitalization (i.e., the total dollar value of its stock). Stock indices cover a variety of different sectors. For example, the Dow Jones Industrial Average contains 30 blue-chip stocks that represent the industrial sector. The S&P 500 index includes 500 of the largest blue-chip U.S. companies. The NYSE index includes all the stocks that are traded at the New York Stock Exchange. The Nasdaq 100 includes the largest 100 companies that are traded on the Nasdaq Exchange. The most popular U.S. stock index futures contract is the E-mini S&P 500 futures contract, which is traded at the Chicago Mercantile Exchange (CME).
Prices - The S&P 500 index rallied steadily during 2013 and progressively posted new record highs. The S&P 500 index rallied by 30% in 2013 and extended the sharp recovery rally that began in early 2009. The U.S. stock market during 2013 received a boost from decent U.S. economic and global economic growth and from the Fed's continued aggressive monetary policy involving zero interest rates and its QE3 program.
The stock market rallied in 2013 despite several headwinds for consumers that included (1) $150 billion in higher taxes on January 1 with the end of the 2 percent payroll tax holiday, (2) the $1.2 trillion of automatic spending cuts over 10 years that went into effect on March 1, 2013, resulting in significant across-the-board spending cuts for social and defense spending due to sequester, and (3) a hike in tax rates on joint income above $450,000.
The stock market in 2013 saw support from the Fed's willingness to continue its third quantitative easing program (QE3) involving the purchase of $85 billion per month of Treasury and mortgage securities.
The Fed at its September 2013 meeting was expected to begin tapering QE3. However, the Fed surprised the markets and kept its QE3 program intact until December 2013, mainly because of the uncertainty caused by the U.S. government shutdown in October 2013. The Fed did finally start to taper QE3 by $10 billion in December 2013 and is expected to continue cutting QE3 by $10 billion at each subsequent FOMC meeting until QE3 ends in Q4-2014. Nevertheless, the stock market should still garner support on the expectations for the Fed to keep its zero interest rate policy in place until at least 2015.
The U.S. government shutdown on October 1-16 caused a sharp drop in U.S. consumer confidence in September and October 2013, but did not have a major negative impact on the economy. The shut-down subtracted only about -0.2 points from U.S. GDP in Q4. U.S. GDP growth in 2013 remained weak at about +1.9%, well below the post-war average U.S. GDP rate of +3.3%. Looking ahead, the market consensus is for only a slow improvement in U.S. GDP growth to +2.9% in 2014 and +3.0% in 2015.
Stock were able to rally sharply during 2013 despite the fact that S&P 500 earnings grew by only about +6%, down from +8% in 2012. S&P 500 stock prices were able to outperform earnings growth mainly because the markets became more confident that the global crisis was over and thus became more confident about the earnings outlook. That allowed the forward price/earnings ratio to move to a 4-year high of 16.3 by late 2013, which was above the 10-year average of 14.8 but below the 30-year average of 17.5. This reasonable valuation level leaves room on the upside for further gains in stock prices. Looking ahead, the market is expecting S&P 500 earnings growth in 2014 of about 11%.
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