Market Cap Weighted Stock Indexes – Common, but Flawed

Wednesday, November 25, 2009

673776_sundialMarket capitalization is commonly used for weighting stocks in an index. In normal times, this is a sound practice when index companies vary widely in size. However, at times market cap weighting produces misleading information. Here’s what happens…

The Standard & Poor’s 500 Stock Index (S&P 500) is the best-known market capitalization (“market cap”) weighted US stock index. Standard & Poor’s carefully selects the 500 companies to represent the overall stock market. The sum of the market caps equals over 3/4 of the entire US stock market.

With so many companies, there is a broad spread of size. The market cap dynamics at work inside the S&P 500 can be seen in the following graph (as of November 20).

S&P 500 wtg

Notice that there are only a few companies with market capitalizations over $100 billion (21), and there are many below $10 billion (about 285). The cumulative market cap shows the spread: 25% of the S&P 500 is in only the top 13 companies; 50% is in the top 45; and 75% is in the top 140. The bottom 250 companies account for only 12%. (Note: 35% is in the Dow Jones Industrial Average’s 30 companies.)

This skewness is not the problem. Rather, it’s the dependence on market cap to determine weighting. There are times when popular investment themes drive market caps up significantly for a subset of stocks. When the move gets carried away (as in the internet bubble of 1999-2000), the S&P 500 becomes misshaped. The “market” characteristics then shift towards the fad. During the internet bubble, the S&P 500 began to look like a growth fund.

Finally, though, fundamentals win out, and the trend tops and reverses. The market characteristics return to “normal” as the overblown market caps drop.

The solution is not to take the S&P 500 as the final word in stock market statistics. Like with any investment data, unusual situations can require making allowances.

(My present interest is to focus on leading companies, starting with those in the Dow Jones Industrial Average. I believe that index, more than the S&P 500, can help us understand today’s stock market characteristics and trends.)

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John Tobey on Seeking Alpha

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November 2009