Straits Times Index as a Capitalisation-Weighted Index. Here is something to watch out.

The Straits Times Index (STI) is regarded as the benchmark index for the Singapore stock market. It tracks the performance of the top 30 companies listed on the Singapore Exchange. The STI uses a capitalization-weighted methodology to calculate performance. What that means is it uses the market value of each stock of the STI and weighs that against that stock’s percentage of market share. Many other stock market indices are also capitalization-weighted such as FTSE 100, S&P500 and NASDAQ Composite.

For the past 6 months, STI has risen about 7.1%. By just looking at the gain, one may think that most if not all of its components are rising about the same amount. After all, STI is tracking the performance of the top 30 companies which is a good proxy of the general stock market conditions. You will be in for a surprise.

Below is a chart showing the performance of all the 30 components in the STI over the last 6 months. The STI itself is plotted as the green area. We can see that a large portion of the components actually underperformed the STI. And a large portion of these underperformers are in the negative territory.  There are only 8 components that outperformed the index. 3 of these are the local banks DBS, OCBC and UOB. During this period, DBS gained 37%, UOB 22% and OCBC 16%. As the 3 local banks constitute the few top heavy-weight components in the index, a rally in the banking sector (due to expectation of higher earnings from recent increase in rates) would have a significant positive impact on STI as well even though majority of other sectors are under performing. Based on the chart, the general market is not doing that well after all. When I talked about undercurrent in some of my weekly analysis posts, this is what I meant (My system is able to perform the analysis based on the whole market rather than only the STI components, thanks to the power of computing.)

This highlights one of the disadvantages of market cap-weighted indexes, that they are prone to risk of concentration as what is happening now with the banking sector solely driving up the index. The opposite may happen as well. If the banking sector falls, STI will most likely to follow suit.

I hope this article has provided you with some good insights and a different perspective in analysing the overall market conditions.

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