A New Type Of Stock Index

Right now, all sorts of index tracking investments like Exchange Traded Funds (ETFs), contracts for delivery (CFDs), index futures, options and plain vanilla open-ended index mutual funds are very popular.  ETFs alone now account for up to 40% of all trading volume on exchanges.

This makes the subject of how indexes are constructed very important.  

Almost all broad indexes like S&P 500 and Nasdaq 100 are capitalization weighted, i.e. a stock's weight in the index increases as its stock price rises.  Right now, the top 5 companies in NASDAQ 100 account for a massive 40% of the index value (Apple, Microsoft, Amazon, Google, Tesla - in that order). The next five add just another 13% (FB, NVIDIA, PayPal, Intel, Comcast).

The index is obviously extremely top heavy and narrow.  Combine this fact with the prevalence of index tracking and you have a vicious cycle of bubble making: a stock rises, its index weight increases and funds must buy more to increase their exposure to the stock... Also, as new funds are created they too add to the buying pressure.  You can see the problem...

What if we constructed a different type of index based on, say, rolling 12 month net income or, better yet, rolling 24 months to average out any unusual one time events, such as write-offs or gains from subsidiary spin-offs/sales. 

Here's a side by side comparison of the 10 top NASDAQ companies using the current market capitalization method versus the rolling 12 month net income method.  The percentages have been normalized as if the index had only 10 members.

	NEW INDEX		PRESENT INDEX
AAPL	22.8%	AAPL	21.1%
MSFT	17.6%	MSFT	17.9%
GOOG	16.0%	AMZN	15.9%
FB	11.6%	GOOG	13.1%
AMZN	8.5%	TSLA	8.1%
INTC	8.3%	FB	6.3%
CMCSA	4.8%	NVDA	5.3%
CSCO	4.5%	PYPL	4.7%
PEP	2.9%	INTC	3.9%
AMGN	2.9%	CMCSA	3.7%
TOTAL	100.0%		100.0%

Three stocks (Tesla, NVIDIA and PayPal) have been removed from the top 10 since their net income doesn't make the cut and have been replaced by Cisco, Pepsi and Amgen. The relative positions have also changed, with Google, FB, Intel and Comcast moving up and Amazon dropping.

Why use net income? It is a pretty good measure of a company's real impact on the economy, as opposed to its share price which gyrates daily.  Just look at Tesla...

I could even go one step further and construct an index weighted by dividends paid - now that would be revolutionary! Imagine, real money, real income to shareholders as a measure of the company's importance to the economy... somehow, I don't think this won't go down well with most CEOs (big smile).

Anyway, the real danger of indexing by market cap right now is that it blows the speculative bubbles ever bigger.  Somehow, it must be addressed.