Market cap weighted indexes such as S&P 500 Index and NASDAQ Composite, and NDX 100 Index are important benchmark stock market indexes as many ETFs and passive index mutual funds are based on these underlining indexes including SPY and QQQ. Market cap weighted indexes tend to be over-exposed to the larger market cap weighted names within the index. They are also prone to underweight the lower market weighted names in the index. This can be a blessing or a curse depending on the performances of the largest components.
It becomes a blessing when the largest market-cap weighted names are collectively trending higher. It becomes a curse when the market cap weighted names are overvalued/extended and begin to exert undue influences on the direction of the index.
SPDR S&P 500 ETF Trust (SPY) is one of the most popular of the tradeable ETFs. The largest market cap weighted names in SPY are: AAPL (4.86% mkt-cap), MSFT (4.57%), AMZN (2.90%), FB (1.96%), BRK.B (1.64%), GOOGL (1.58%), GOOG (1.58%), JPM (1.58%), JNJ (1.41%), and V (1.23%). The largest sectors are: Technology (23.74%), Healthcare (14.01%), Financial (12.8), and Communication Services (10.56%). A brief review of SPY clearly shows the top 10 market cap weighted names comprised 23.31% of the ETF and six of the ten names are technology or technology related stocks.
Invesco QQQ Trust (QQQ) is another popular ETF available for investors. The largest market cap weighted names in QQQ are: AAPL (12.05% mkt-cap), MSFT (10.66%), AMZN (8.03%), FB (4.57%), GOOGL (4.24%), GOOG (4.23%), INTC (2.83%), CMCSA (2.27%), CSCO (2.22%), and PEP (2.08%). The largest sectors are: Technology (47.43%), Communication Services (21.32%), Consumer Discretionary (14.75), and Healthcare (6.98%). The top 10 market cap weighted names in QQQ account for 53.18% of the ETF and nine of the top 10 names are technology or technology related stocks.
Based on the above two analyses of SPY and QQQ and the increasing popularity of ETFs and passive index funds it is important for investors and traders to understand the importance of the largest components of the ETFs, namely the top 10 market cap weighted stocks. If you believe in the mean reversion concept then any stocks or sectors that rise or decline too far above or below their equilibrium levels, then they will need to correct their excesses by mean reverting before resuming with their dominant and prevailing trends.
Enclosed is a chart of the SPY accompanied by the daily Bollinger Bands. Also attached below are the top market-cap weighted names within SPY accompanied by their respective Bollinger Bands. The top of the Bollinger Bands often warns of near-term overbought conditions. The bottom of the Bollinger Bands hints of near-term oversold conditions and the middle of the Bands represents near-term equilibrium conditions. Bollinger Band studies are most useful when the top and bottom of the bands contract sharply as this often alerts us to an unsustainable situation prompting a major move in the price trend. We hope this technical exercise will help you prepare for any near-term fluctuations in the ETF as well as potential near-term trend changes in the individual names in the underlining index/ETF.