From the February 01, 2012 issue of Futures Magazine • Subscribe!

How to market-time with stock fundamentals

The reality is, at least according to one analysis of the stock market, most returns come from dividends, and over long periods stocks do not perform better than inflation (see “How to get active in long-term investing,” December 2011). These concepts, which run counter to popular assumptions, are rooted in the worst of times: The 1929 and 1987 crashes, the 2000 Internet bubble, the 2000-02 bear market, the 2008 banking disaster and the current euro crisis.

This understanding is important when formulating strategies to predict stock market returns based on fundamental and economic data. We’ll test these ideas on S&P 500 index data from Feb. 28, 1930 through July 29, 2011. We’ll begin with a quick look under the hood of the index itself.

The S&P 500 (SPX/INX) is an index of U.S. equities. It includes 500 U.S. large-cap companies and is accepted as a reliable gauge of the health of the U.S. market. All the stocks in the S&P 500 are listed on the New York Stock Exchange or Nasdaq.

The stocks in the S&P 500 index are not necessarily the largest companies, but those with the largest market capitalizations (at least $5 billion). Companies are selected based on liquidity, sector and other factors.

The significance of the index doesn’t just sit with its popularity among retail traders. Exchange-traded funds (ETFs) and index-linked funds base much of their holdings on the S&P 500. Companies moving into and out of the index can cause fluctuations based on balancing-related sales and purchases alone. Also, because the index is considered a benchmark by which actively traded funds are judged, its rise and fall can spark shifts in large trader sentiment.

To calculate the S&P 500, we first need to calculate the market capitalization of each company. This is simply the total outstanding shares multiplied by the stock price. The sum of these values is referred to as the total market capitalization of the index. The weighted market capitalization for each company comes from dividing each market capitalization by the sum total capitalization and multiplying the result by 100.

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