Investing in the US stock market: a beginner’s guide

by Tom Bailey from interactive investor |

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As the world’s biggest market, the US cannot be ignored by any investor – here’s what you need to know.

The US is the world’s largest economy and is home to the biggest and most liquid financial markets. The total market value of US equities dwarfs that of the rest of the world. When measured using the MSCI All Country World index, the US accounts for around 58% of the entire index. In second place is Japan, with just 6.9%. US stocks, therefore, are a part of the market that no investor can ignore.

The main indices

The two most popular indices for US stocks are the Dow Jones Industrial Average and the S&P 500. 

The Dow Jones is the world’s oldest index of stocks, dating back to the late 19th century, when it was first compiled by Charles Dow. 

Owing to its long history, the Dow Jones is often cited by non-specialist news outlets as a general gauge of the US economy’s performance. However, the Dow Jones is composed of just 30 stocks and is “price weighted”, meaning that stocks with the highest share price receive the greatest weighting. Therefore, most investors view it as somewhat flawed and prefer the S&P 500. 

As the name suggests, the S&P 500 is composed of 500 stocks. This means the index is a much more representative sample than the Dow. It is also market-capitalisation weighted, which is generally seen as a better way to construct an index, due to market capitalisation being a better gauge of the changing value of a listed company than price alone. As a result, most ETFs available to investors will use the S&P 500, while active fund performance is often benchmarked against this index. 

The S&P 500, however, does have some quirks. In contrast to most big benchmark indices, the S&P 500 requires companies to have been profitable for four consecutive quarters to be eligible to join the index.  

The index also has a committee, which decides on membership based on certain “qualitative” factors. This is globally unique, with other big flagship indices such as the FTSE 100, Cac-40 or Dax 30 not having such requirements. 

For those looking to track the S&P 500, there is no shortage of ETF and index funds that do so. Both the Vanguard S&P 500 UCITS ETF GBP (LSE:VUSA) and iShares Core S&P 500 ETF USD Acc GBP (LSE:CSP1) charge just 0.07%. Generally, investors should avoid anything that charges more than 0.15% to track the S&P 500. 

Tech and small cap

Alongside the S&P 500, another favourite index of investors is the Nasdaq. It is often used a US tech index owing to its heavy weighting towards tech stocks. However, the Nasdaq itself is a stock exchange, with its name also being used by several indices tracking stocks that trade on it. The most important indices are the Nasdaq Composite and the Nasdaq 100. 

The Nasdaq Composite includes more than 3,000 stocks on the Nasdaq exchange, while the Nasdaq 100 includes 100 and uses a slightly different methodology. Investors are likely to see the Nasdaq Composite most frequently cited in the news. However, most ETFs available to UK investors mirror the Nasdaq 100, such as Invesco EQQQ NASDAQ-100 ETF GBP (LSE:EQQQ) or iShares NASDAQ 100 ETF USD Acc GBP (LSE:CNX1)

When it comes to the small-cap end of the US market, the most popular index is the Russell 2000. This index is the 2,000 smallest companies of the Russell 3000 index. There are several potential ways that investors can track this index, such as the SPDR® Russell 2000 US Small Cap ETF GBP (LSE:R2SC) or L&G Russell 2000 US Small Cap ETF GBP (LSE:RTWP), among others. There is also the MSCI USA Small Cap index, which can be tracked using iShares MSCI USA Small Cap ETF USD Acc GBP (LSE:CUS1).

Is the US market too expensive?

The past decade has been characterised by strong performance from the US market. Over the past 10 years, the S&P 500 has provided a sterling total return of 267%. Meanwhile, the MSCI All Country World Index Excluding USA has returned just 79%. 

However, this sustained performance has led some to believe that the US market is now “too expensive”. Broadly, this means that stocks in the S&P 500 are on average trading at high multiples. For example, the S&P 500 is currently trading on a price-to-earnings ratio of somewhere in the 30s. This is way above its historic norm, with the average PE ratio over the past 100 years being around 15x. Therefore, some people argue that US equities will either suffer a fall or produce much lower returns in the future. 

Of course, trying to predict such things is almost impossible. Over the past few years, many bearish commentators have pointed out that the US market is expensive and predict prices coming down. While there have been some notable and sharp sell-offs, the general trend has been for US equities to continue to perform well.

It is also worth noting that historical comparison of how “cheap” or “expensive” the US market is are not so straightforward. The S&P 500 is a different beast to what it was 50 years ago, being composed of very different companies now compared to in the past. For much of the 20th century, industrials, energy producers and other capital-intensive businesses made up a bigger chunk of the index than they do today. Now, tech firms make up a much bigger chunk of the market.

A global index?

Despite its historic role as an advocate of greater global trade and economic integration, the US economy is actually relatively closed to the rest of the world. Some countries such as Japan and Germany are highly reliant on world trade and, therefore, the performance of their economies is heavily tied to that of the overall global economy. However, the US economy is much more domestically focused, with its performance driven by consumer sentiment. 

The domestic-driven nature of the US economy is also reflected in the S&P 500. Although it fluctuates year to year, usually about 60% of earnings for companies in the S&P 500 are derived from domestic sales. This means that the key driver for the performance of the index is usually the overall health of the US economy.

However, this is changing. In recent years the trend has been for the S&P 500 to become more international. As Cullen Roche notes in his book Pragmatic Capitalism, in 1990 the S&P 500 generated 22% revenue from abroad, compared to today’s roughly 40%. He notes:

“The S&P 500 is no longer a US index. It is becoming a global index, and understanding its constituents requires a global picture. The big picture matters to market participants because US stock markets are becoming increasingly dependent on a stream of foreign revenues as they tap into foreign markets for business expansion.”

This also means that the S&P 500 moves increasingly in tandem with global equities. Roche notes that between 1990 and 1995, the average correlation between US and global equities was 29%. Between 2005 and 2010, the average correlation had risen to 73%. 

Active or passive?

When people say “markets are efficient” what they usually mean is that the US market is efficient. The original work on market efficiency was based on the US market, which is also the case for many subsequent studies. The US market is the most watched in the world. Thousands of professional investors and analysts are poring over company results and monitoring trends, meaning that the price of US stocks generally reflect the best approximation of fair value. There aren’t many undiscovered bargains. 

This means that the US market is incredibly hard to beat. Generally, fund managers underperform if they are stock picking in the S&P 500. 

The US market has also become harder to beat due to the continued outperformance of a handful of large-cap tech stocks. Stocks such as Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT) now compose a huge percentage of the index. They have also outperformed the broader index. 

Therefore, for a fund manager to provide outperformance, they will need to have a huge weighting to a handful of large-cap stocks. Many fund managers, however, are reluctant to do this, either owing to concentration risk or the view that they have become overvalued due to their strong performance in recent years.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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