- 2000: Volume 9, No. 2 Stock Index Weightings Provide Clues to Index Movement

Not all stock indexes are created equal. They represent varying numbers and types of stocks. They are weighted and calculated in different ways. That's why it is critical for stock index traders to understand the design, weight and calculation method of the popular indexes. The design specifies which stocks are included in the index and how it may be categorized, e.g., blue-chip or broad-based. How the index is calculated determines which stocks have the most influence in the index's movement.

The dominant exchange-listed stock index contracts around the world tend to be based on indexes that represent a country's entire stock market, although those that focus on only the largest stocks also are popular. In addition, most indexes are capitalization-weighted, which means that the stocks with the most outstanding shares at the highest price are weighted the heaviest in the index and thus have the most influence on index movement. Indeed, of the 10 most popular index contracts traded in 1999 (Table 1), eight fall into that category. The Standard & Poor's 500 Index is one of the best-known "market-cap" indexes.

Table 1

Top Ten Stock Index Contracts in 1999 (futures, options on futures, cash options)
Rank	Index	Exchange	Volume (millions)
1 2 3 4 5 6 7 8 9 10	CAC 40 Standard & Poor's 500 Deutscher Aktienindex (DAX) Swedish Equity Index (OMX) Nikkei 225 FTSE 100 E-mini S&P 500 Dow Jones Euro Stoxx 50 Dow Jones Industrial Average MIB 30	MONEP CME/CBOE Eurex OM Stockholm/OM London Osaka Stock Exchange LIFFE CME Eurex CBOT/CBOE IDEM	108.6 55.9 45.5 17.7 14.8 14.5 11.0 9.1 7.4 7.3
Source: Futures Industry Association

A modified-capitalization index seeks to limit the influence of the largest stocks in the index, which otherwise would dominate the entire index. The Nasdaq-100 Index is a prime example of this type of weighting scheme, as it sets a limit on the percentage weight of the largest stocks and a group of stocks. In some modified-cap indexes, the number used as the outstanding shares portion of the equation is adjusted to reflect only those shares that are freely available for trade, ignoring those shares held in solid hands, such as individuals who own the company.

A price-weighted index sums the prices of each stock in the index and equates the total to a designated index starting value through use of a divisor. In the United States, the Dow Jones Industrial Averageand PSE Technology Index are price-weighted. The only other actively traded, price-weighted index is the Nikkei 225 Index of Japanese stocks. In these indexes, the stocks with the highest price are the most influential. Beware that if a stock splits, its price is adjusted to maintain the same market capitalization with the new number of shares available, and it will then have less weight in a price-weighted index.

The fourth variation is equal-weighting, which means that each stock's percentage weight in the index is equal, and all stocks have an equal influence on index movement. The Value Line Index, trading mainly as the Mini Value Line futures contract at the Kansas City Board of Trade, is the lone example of this type of weighting scheme. Equal weighting tends to dampen volatility as well as neutralize the influence of both high-priced and highly capitalized stocks.

All four types of index weightings are represented among the top 10 trading U.S. stock indexes for 1999 (Table 2). The tables of the top 10 influential stocks in an index that accompany the description of the following representative indexes are only a snapshot of which stocks carried the most weight on the date indicated. Indeed, the percent weight for each stock changes as prices change throughout the trading day.

Table 2

Top Ten U.S. Stock Index Contracts in 1999 (futures and options on futures)
Rank	Index	Exchange	Volume (thousands)
1 2 3 4 5 6 7 8 9 10	Standard & Poor's 500 E-mini S&P 500 Dow Jones Industrial Average Nasdaq-100 E-mini Nasdaq-100 Nikkei 225 Russell 2000 Standard & Poor's MidCap 400 Russell 1000 Mini Value Line	CME CME CBOT CME CME CME CME CME ICE KCBT	31,607 11,008 4,125 2,587 682 520 364 330 231 33
Source: Futures Industry Association

Market-capitalization: Standard & Poor's 500

The S&P 500 Index is the benchmark used by portfolio managers around the world for judging their performance against the U.S. stock market, with more than trillion indexed to it. Introduced in 1957 by the Standard & Poor's Corporation, a financial ratings, research and news organization, the Index was designed to represent the market value of 500 leading companies in leading industries. Since 1968, the S&P 500 has been the only measure of stock market performance in the Index of Leading Economic Indicators.

The highest-priced stocks with the most outstanding shares have the greatest influence on movement of the S&P 500 Index because it is weighted by market capitalization, or price times shares outstanding. Thus, a glance at the largest stocks in the Index, according to capitalization, can provide a quick insight into the S&P 500's current situation. At the end of February, the stocks shown in Table 3 were the 10 largest in market capitalization in the S&P 500 Index and equaled 25.8 percent of the Index total market value.

Table 3

Top Ten Stocks in Standard & Poor's 500 February 29, 2000
Rank	Stock	Symbol	Market Capitalization (million dollars)	Percent Weight
1 2 3 4 5 6 7 8 9 10	Microsoft Corp. Cisco Systems General Electric Intel Corp. Exxon Mobil Corp. Wal-Mart Stores Oracle Corp. Lucent Technologies Internat'l Bus. Machines Citigroup, Inc.	MSFT CSCO GE INTC XOM WMT ORCL LU IBM C	465,158 452,217 434,305 377,533 260,087 217,654 209,499 189,655 185,218 174,686	4.0 3.9 3.8 3.3 2.3 1.9 1.8 1.7 1.6 1.5
	Total weight of 10 largest stocks			25.8
Source: Standard & Poor's Corporation

Standard & Poor's Corp. has sole responsibility in maintaining the S&P 500 Index and calculating the Index value. Calculating the S&P 500 Index requires multiplying each stock's price by the number of outstanding shares to obtain the stock's market value. All 500 market values are totaled and then compared to those of the base period (1941-1943 = 10) to derive the Index value. Standard & Poor's calculates the Index continuously during the New York Stock Exchange trading day and displays the values every 15 seconds. Modifications to the Index due to stock splits or dividends, for example, are achieved through changing the Index divisor, daily if necessary.

Modified Market-capitalization: Nasdaq-100

The Nasdaq-100 comprises the top 100 non-financial stocks (both domestic and foreign) listed on the Nasdaq Stock Market, an electronic marketplace created in 1971 by the National Association of Securities Dealers. The index was created on February 1, 1985 with a base value of 250. By the end of 1993, the Nasdaq-100 had nearly reached the 800 level, and was halved on January 3, 1994.

In December 1998, the Nasdaq-100 Index became a modified-capitalization index in order to enhance diversification of the underlying index and its representation of the overall market for Nasdaq stocks. Before the change, the top five stocks in the index accounted for more than 60 percent of the index weight; after the change, those stocks equaled just 40 percent of the index weight. At the end of February, the 10 largest stocks in the index equaled 43 percent of its weight; the top five equaled 29 percent (Table 4).

Table 4

Top Ten Stocks in Nasdaq-100 February 29, 2000
Rank	Stock	Symbol	Market Value (million dollars)	Percent Weight
1 2 3 4 5 6 7 8 9 10	Microsoft Corp. Cisco Systems, Inc. Intel Corp. Qualcomm, Inc. Oracle Corp. JDS Uniphase Corp. Sun Microsystems, Inc. Nextel Communications, Inc. Veritas Software Corp. MCI Worldcom, Inc.	MSFT CSCO INTC QCOM ORCL JDSU SUNW NXTL VRTS WCOM	298,140 292,607 248,327 224,830 165,586 162,798 122,856 115,405 97,872 85,586	7.0 6.9 5.8 5.3 3.9 3.8 2.9 2.7 2.3 2.0
	Total weight of 10 largest stocks			42.6
Source: The Nasdaq Stock Market, Inc.

The Nasdaq-100 is influenced most by the component stocks that have the highest market value. The market value of an index security is equal to the security's price multiplied by a "depository receipt multiplier," which is the figure used instead of shares outstanding to determine a stock's market value for weighting purposes in the index.

The modified-capitalization weighting scheme for the Nasdaq-100 limits the weight of any single stock to 24 percent of the index. It also limits the combined weight of all securities with individual weightings of at least 4.5 percent to no more than 48 percent of the total market value of the index. Readjustments to the index are reviewed quarterly, but made only if the 24 percent and 48 percent thresholds are violated.

The Nasdaq-100 Index level equals the current market value of component stocks multiplied by 125 and then divided by the stocks' market value of the adjusted base period. The adjusted base period market value is determined by multiplying the current market value after adjustments times the previous base period market value and then dividing that result by the current market value before adjustments.

The adjustments relate to capitalization changes due to stock additions and deletions as well as changes to the depository receipt multiplier for component securities other than stock splits or stock dividends; no adjustments are made for cash dividends. Thus, the index reflects only the effects of price changes in the stocks resulting from market action.

Price-weighted: Dow Jones Industrial Average

The Dow Jones Industrial Average is arguably the best-known stock measure in the world. First published on May 26, 1896 by Dow Jones & Company, it had tallied nearly 60 years of stock market history before another U.S. stock market index was developed. That longevity accounts for its continued popularity today as a measure of "the market" with individuals, institutions and news organizations.

The DJIA is an index of 30 of the largest, most liquid blue-chip U.S. stocks, a number that has held steady since 1928. When the Dow was first introduced, it contained 12 stocks, a figure that was expanded to 20 in 1916. General Electric is the only stock in the current index that also was in the original configuration. Today, editors of The Wall Street Journal, who maintain and update the Average, take a very broad view of what constitutes an "industrial" company in today's technology and service-oriented economy. Indeed, two stocks in the top 10 list, Microsoft and Intel, have been Dow stocks only since November 1999 (Table 5).

Table 5

Top Ten Stocks in Dow Jones Industrial Average March 1, 2000
Rank	Stock	Symbol	Price (dollars/share)	Percent Weight
1 2 3 4 5 6 7 8 9 10	American Express Co. Hewlett-Packard Co. General Electric Co. Intel Corp. J.P. Morgan & Co. Internat'l Bus. Machines Corp. Microsoft Corp. Procter & Gamble Co. Minn. Mining & Mfg. Co. Exxon Mobil Corp.	AXP HWP GE INTC JPM IBM MSFT PG MMM XOM	135.5000 133.6250 131.3750 115.8750 110.0000 100.4375 90.8125 88.2500 86.1250 76.0625	6.6 6.5 6.4 5.7 5.4 4.9 4.4 4.3 4.2 3.7
	Total weight of 10 largest stocks			52.1
Source: Dow Jones & Company

The DJIA is price-weighted, which means that stocks with the highest price will have the most influence. Other characteristics to watch for include: (1) volatile stocks with large price swings; (2) a change in the index components, which may alter the hierarchy of influence; and (3) a stock split, which will decrease the stock's influence on the index because its price declines as the number of shares increases.

When Charles Dow first calculated the Dow Jones Industrial Average in 1896, he did what any reasonable person would do with only paper, pencil and math skills-he added the closing prices of the 12 stocks in the index and divided by 12 to get an average price (40.94 on May 26, 1896).

By 1928, when the number of components in the index reached 30, the editors began using a special divisor rather than just the number of stocks in the index in order to avoid distortions due to stock splits or changes in the index make-up. On October 1 of that year, the divisor was 16.02.

Today, the DJIA is the sum of each component stock's closing price at its "home exchange" (as opposed to the "composite" closing value), divided by the current divisor. With the DJIA trading in the 10,000 area in 1999, the divisor has now extended eight places beyond the decimal point, and each -per-share move in a component stock equals about a five-point move in the Dow. Dow Jones calculates the index on a real-time basis with every trade that occurs in the component stocks and distributes the information every few seconds; the DJIA is not calculated when the NYSE is closed.

Equal-weighted: Value Line

The Value Line Arithmetic Index is an equal-weighted offering of approximately 1,600 large-, mid- and small-cap stocks traded on the NYSE, Nasdaq, American Stock Exchange and in Canada. Equal weighting de-emphasizes the importance of blue-chip stocks as price movement in each stock is given equal weight in calculating index change.

As an example, International Business Machines (IBM) is included in the Value Line, Standard & Poor's 500 and Dow Jones Industrial Average, but its influence on index movement ranges widely. In the Value Line, with its equal-weighting approach, IBM's weight equals just 1/1,600 stocks, or 0.0006 percent, the same percentage weight as every other stock in the index. In the S&P 500, IBM was weighted at 2.6 percent at the end of February while it carried a weight of 4.9 percent of the DJIA on March 1.

Susan Abbott Gidel is president of CGA Communications Group in Chicago and author of Stock Index Futures & Options: The Ins and Outs of Trading Any Index, Anywhere, published in November 1999 by John Wiley & Sons. The book is available for purchase at www.educatedinvestor.com, home of Educated Investor^©, which also publishes information about stock indexes and the futures industry, including links to stock index developers. Ms. Gidel can be reached by e-mail at: sgidel@educatedinvestor.com.