The effort to limit the spread of the COVID-19 virus has caused major disruptions in our daily lives, and wild fluctuations in the stock market. While the effect on our lives are somewhat in our control, the stock market volatility may seem unpredictable and chaotic. However, there are mechanisms in place to prevent the market from careening out of control. These are the “circuit breakers” we have seen go into action several times in recent days. These circuit breakers are trading curbs put in place to curb panic selling by allowing traders time to assess their decisions and allow time for accurate information to be exchanged.
Currently, the New York Stock Exchange has three levels of circuit breakers which trigger a halt in trading: 7% (Level 1), 13% (Level 2), and 20% (Level 3). These levels mark percentage drops in value in the S&P 500 Index, based on the preceding trading day’s closing value of the index. Depending on the point drop and time of day, the automatic actions can vary. Level 1 (7%) and Level 2 (13%) declines result in a 15-minute trading halt unless they occur after 3:25 p.m., when no trading halts apply. A Level 3 (20%) decline results in trading being suspended for the rest of the day. So far, we have only seen Level 1 circuit breakers, which indicates that these curbs are working to control the turmoil somewhat.
In times like these, it’s best to understand the landscape. What is the S&P 500? What are the other stock indices? Why is the S&P 500 the bellwether?
A stock index — or stock market index – measures the value of a section of the stock market. It is computed from the prices of selected stocks (typically a weighted average). Investors and financial managers use stock indices to describe the market and compare the relative return on specific investments. Some indices are designed to indicate the broad performance of the overall market, while others follow a much narrower subsector of the market.
Let’s look at three: The Dow Jones Industrial Average, the NASDAQ Composite, and the S&P 500.
Dow Jones Industrial Average
The Dow Jones Industrial Average (known as “the Dow”) is one of the most closely followed stock market indexes in the world. The Dow was created in 1896 to serve as a proxy for the broader U.S. economy and is the second-oldest stock market index in the U.S., after the Dow Jones Transportation Index (both were put together by journalists Charles Dow and Edward Jones, who also founded The Wall Street Journal, in which the index first appeared). When the Dow first began, it included just 12 companies that were almost purely industrial in nature, including the American Cotton Oil Company (now Unilever), the Laclede Gas Company (still in operation, but doing business as Spire, solely in the St. Louis region), and the United States Leather Company (now defunct). General Electric, the last of the original Dow components, was dropped from the index in 2018 (one of a few times the firm has dropped in the last 124 years).
As the economy changes over time, so do the index components. The Dow typically changes its makeup when a company is in financial distress and becomes less representative of the economy, or when a broader economic shift occurs.
The Dow currently consists of 30 large-cap, blue-chip companies, most of which are household names such as Apple, Disney, Home Depot, McDonald’s, Microsoft, and Nike It is a price-weighted average, which means stocks with higher share-prices receive a greater weight in the index. This is different from the market-weighted indices NASDAQ and S&P, which we will look at next. Those weight stocks based on market capitalization — the value of a company calculated by multiplying the total number of shares by the present share price.
Critics have said that the sample of 30 companies in the Dow is too small to serve as an accurate measure of the stock market’s performance. However, the Dow has been measuring the stock market for more than a century, which gives it a great deal of credibility.
NASDAQ Composite Index
The NASDAQ Composite Index is a market capitalization-weighted index of approximately 3,000-plus common equities listed on the Nasdaq stock exchange, the second-ranked exchange, behind only the New York Stock Exchange (NYSE). Included in the index are all listed common stocks, American Depositary Receipts (ADRs), limited partnership interests, real estate investment trusts (REITs), and tracking stocks. Closed-end funds, convertible debentures, exchange-traded funds (ETFs), preferred stocks, rights, warrants, units, and other derivative securities are not included.
As of March 15, 2020, the industry weights of the NASDAQ Composite’s individual securities are as follows: technology at 48.39%, consumer services at 19.43%, health care at 10.21%, financials at 7.21%, industrials at 6.85%, consumer goods at 5.51%, utilities at 0.81%, telecommunications at 0.72%, oil and gas at 0.55% and basis materials at 0.32%. Because of these weightings, the NASDAQ Composite is a good proxy for technology stocks.
The NASDAQ Composite also uses a market-capitalization weighting methodology. The index’s value equals the total value of the index share weights of each of the index securities multiplied by each security’s last reported price. This total is then divided by an index divisor, which scales the value to a more appropriate figure for reporting purposes. The index is calculated continuously throughout the trading day, but it is reported once per second, with the final confirmed value being reported at 4:16 p.m. each trading day.
S&P 500
The S&P 500 is a stock market index that tracks the 500 most widely held stocks on the New York Stock Exchange. Established in its current form in 1957 in an expansion from the Standard & Poor’s 90-stock index, the S&P 500 is widely regarded as the most accurate gauge of the performance of large-cap American equities. The S&P 500 seeks to represent the entire stock market by reflecting the risk and return of all large-cap companies. Despite the S&P 500’s focus on the large-cap sector of the market, this index is considered representative of the market because it includes a significant portion of the total market value. The 500 companies included in the S&P 500 are selected by committee of analysts and economists at Standard & Poor’s. These experts consider various factors when determining the 500 stocks that are included in the index, including market size, liquidity, and industry grouping. To be included in the S&P 500, a company must be based in the United States and have a market cap of at least $5.3 billion. At least 50 percent of the corporation’s stock must be available to the public and its stock price must be at least $1 per share. Finally, it must have at least four consecutive quarters of positive earnings.
The S&P 500 uses a market capitalization weighting methodology. Market capitalization, or 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. The S&P 500 captures 80 percent of the total market cap of the entire stock market.
The makeup of the S&P 500 industries reflects that of the economy. As of Feb. 27, 2020, the sector weightings in the S&P 500 were Technology (24.03 percent), Health Care (14.11 percent), Financials (12.42 percent), Consumer Services (10.60 percent), Consumer Discretionary (9.89 percent), Industrials (8.93 percent), Consumer Staples (7.34 percent), Utilities (3.56 percent), Energy (3.50 percent), Real Estate (3.13 percent), and Materials (2.50 percent).
Financial professionals consider the S&P a more representative index than the Dow and NASDAQ Composite because the S&P holds about one-tenth of all the publicly traded companies. More importantly, this tenth of the market’s companies collectively represents about 75 percent of the stock market’s total dollar value. Although the NASDAQ Composite has a greater variety of common equities as part of the composite than the other two indices, it is more heavily weighted toward technology-related stocks.
Then there is the difference between the ways the indices are weighted. The Dow is price- weighted, while the S&P and NASDAQ are market capitalization-weighted. One of the shortfalls of the price-weighted method is that it doesn’t consider the overall size and market value of the company. The market capitalization-weighted method will weigh companies based upon the total market value of all their shares (i.e., share price multiplied by the number of outstanding shares). The Dow’s price weighting values companies based on their share price, not total market value. As its name says, the Dow is an average. Thus, a company with a share price of $50 makes up five times more of the index than a company with a share price of just $10, even if the lower-priced stock produces twice the profits or has more shares trading in the market.
Despite the differences between these three indices, professional investors closely watch them all and these indices move pretty close together. Because the Dow is the oldest and one of the most frequently quoted, it is one of the most widely watched. The S&P 500 is watched as a good proxy for the overall market. The NASDAQ Composite is watched, but because of its high percentage of technology stocks, it is used more as a technology indicator than anything else. There are also other, more specific indices that professional investors watch, such as indices for bonds, small cap stocks, and international stocks.
Circuit breakers and the S&P 500
The S&P 500 Index serves as the reference index for daily calculations of the three-level circuit breakers that trigger trading halts. The trading curbs were put in place following the Black Monday crash of October 19, 1987, the largest one-day percentage drop in history. That era’s computer and communications systems were swamped by the huge trading volume, leaving orders unfilled and large funds transfers delayed for hours, exacerbating the panic. This resulted in the Securities and Exchange Commission Rule 80B, which regulates the trading curbs (an amendment in 2013 put in place the three-level circuit breakers, in response to the “Flash Crash” of May 6, 2010, intensified by computer trading programs).
There is a security specific circuit breaker system, like the market wide system, that is known as “Limit Up Limit Down” (LULD). This system is in place to combat security specific volatility as opposed to market wide volatility. Under current rules, a trading halt on an individual security is placed into effect if there is a 10% change in value of a security that is a member of the S&P 500 Index, Russell 1000 Index, or QQQ ETF within a five-minute time frame, 30% change in value of a security whose price is equal or greater than $1 per share, and 50% change in value of a security whose price is less than $1 per share.
The creation and use of the circuit breakers is to facilitate trading and curb panic selling by allowing enough time for information to circulate with the objective of producing an orderly market thereby lending liquidity to trading as opposed to panic selling without buyers on the other side of the transaction. For each sell order placed in the market there must be a buyer. Without the buyer sellers could not sell and we would have no liquidity in the market. When the buy and sell orders cannot be matched, the market volatility increases. By providing the circuit breakers, the trading is stopped for a short period of time, allowing information dissemination and giving investors to “catch up” without the selling turning a market dips into market a rout.
Conclusions- Breakers Work But Do Not Prevent Market Declines
The original circuit breakers worked to the specialist’s advantage to find the other side of the trade. In modern trading however it gives traders and investors time to digest information related to the cause of the move. It still works as intended as demonstrated on March 9th and March 16th during growing investor concerns over the Corona 19 pandemic. During both trading days, circuit breakers arrested a free fall market. Though the market did move lower during the course of both days, the market was able to close without any significant trading gaps. There were buyers out there to match with each seller though not necessarily at a price that both parties were delighted with. It is those huge gaps between what the buyers are willing to pay for shares and the sellers are willing to sell their shares at that creates a panic that produce wild and dramatic swings. Without a meeting of the minds- we do not have a transaction and we don’t have liquidity. Circuit breakers help to provide that liquidity which enables the sellers to sell their shares and the buyers to purchase those same shares. Without these circuit breakers, it would be much worse.