The megacap problem

Module 1 established that a cap-weighted index can move on one company. This lesson is about what to do when that stops being an occasional quirk and becomes the normal state.

What concentration does to your analysis

If the largest few constituents account for a large share of the index, then a technical read of the index is substantially a technical read of those companies. The other constituents are along for the ride at whatever weight they carry.

That is not a reason to stop analysing the index. It is a reason to know what you are actually analysing, and to be suspicious of a market-wide narrative built on a move that a small number of firms produced.

The consequences worth carrying

• Index-level support and resistance can be levels in one or two shares, transmitted.
• A rate-sensitive megacap makes the whole index rate-sensitive, whatever the other constituents do.
• Diversification inside the index is smaller than the constituent count implies - the same counting error as module 4 lesson 7, one level down.
• Sector exposure arrives through the back door: a heavily weighted sector is a position you did not choose.

How to check rather than assume

Concentration is published. Index providers give the weights of the largest constituents, and the top-ten share is the number that matters most.

It changes over time, sometimes quickly. A conclusion drawn from last year's concentration is a conclusion about last year's index, and unlike most things in this module it is a fact you can simply look up rather than infer.

The equities boundary

Analysing those companies individually is the equities track's job, and doing it well is a different skill from index analysis. What belongs here is knowing which companies matter to the index, by how much, and therefore how much of your index view is really a view on them.

What follows

The rest of this module reads the index chart. Keep this lesson in view while doing it: the chart is a weighted sum, and the weights are not even.