Stock Market Indexes -- What Do They Indicate?

Great question. The answer is that they are different because their respective indexes are weighted differently. There are three general ways to measure stocks in index format; there are some additional hybrid methods, but basically the three methods are as follows:

1. Price weighted

2. Capitalization weighted

3. Equal weighted

Price Weighted

A price-weighted index is an index that weights its component stocks based upon each stock's price. The higher the price, the more weight that stock has in a price weighted index. For example: if you had an index with 5 stocks in it and their prices were $2, $4, $6, $8 and $10. The total would be 2+4+6+8+10= 30. Since this is a price-weighted index the $10 stock would compose 33% of the weight of the index (10/30= 33%), whereas the $2 stock would only contribute 7% (2/30= 6.67%) of the total index or approximately 5 fold less than the largest stock.

The Dow Jones Industrials is an example of a price weighted index.

Capitalization Weighted

A capitalization-weighted index (cap-weighted) is an index that weights its components based upon each stock's market capitalization (capitalization = price x number of shares). Once again, like the price-weighted index the stocks with the highest market capitalization would have the greatest influence on the movements of the index since it would be weighted in favor of the stocks with the highest capitalization.

The NASDAQ is an example of a cap-weighted index.

Equal Weighted

An equal-weighted index is an index that weights all its component stocks equally. For example: if you had an index with 5 stocks in it and their prices were $2, $4, $6, $8 and $10. The total would be 2+4+6+8+10= 30. Since this is an equal-weighted index the $10 stock would compose 20% of the weight of the index (1 of 5= 20%), and the $2 stock would also count for 20% (also 1 of 5= 20%) of the total index.

An example of an equal-weighted index is the S&P equal-weighted index you referred to in your question. It has the same 500 stocks that the regular S&P 500 has, but they are all given equal weight.

A PV Index?

Since most of the readers of this article will probably have an interest in renewable energy and photovoltaic’s I thought you might find it interesting if I pointed out how one might approach creating a PV index with just the 21 PV stocks we currently follow. Keeping in mind that First Solar (FSLR) would have a hugely disproportionate influence on such an index as illustrated below:

In the various indexes we have discussed FSLR would have the following weight:

1. Price Weighted = 54%

2. Cap Weighted = 53%

3. Equal Weighted = 5%

As a result, at this very early stage of the solar industries development I think that an equal weighted index would be most appropriate for the solar stock sector, since doing it either of the other ways would simply result in an “FSLR Index” and not an index that would truly reflect what is happening in the industry as a whole.

Mr. Lynch has worked, for 32 years as a Wall Street security analyst, an independent security analyst and private investor in small emerging technology companies. He has been actively involved in following developments in the renewable energy sector since 1977 and is regarded as an expert in this field. He was the contributing editor for 17 years to the Photovoltaic Insider Report, the leading publication in PV that was directed at industrial subscribers, such as major energy companies, utilities and governments around the world. He is currently a private investor and has from time to time been a financial/technology consultant to a number of companies. He can be reached via e-mail at: SOLARJPL@aol.com. Please visit his website for the promotion of solar energy – www.sunseries.net