This week’s Barron’s cover story, Shake Up The Dow!, is the latest attempt to discredit the Dow Jones Industrial Average in its current form.Andrew Bary, the author of the story, offers some ideas to update the index. Unfortunately, his ideas would actually make the Dow less robust and further confuse those who follow it.
Same Ol’ Story
We’ve written about this before. Basically the Dow haters remind everyone that Apple isn’t in it. And if it were, it would be a better representation of the market.
However, Apple is up 5,000 per cent in the last decade, which can’t be said by many stocks in the market. Thus, having Apple in the Dow would’ve actually created a huge bias in the index that doesn’t currently exist.
This particular bias is one that most overlook when they talk about everyone’s favourite index: the S&P 500.
The S&P 500 Is Not Perfect
The S&P is a market cap-weighted index. The obvious bias is that the largest market cap companies have the most influence on the index’s performance. But large cap companies tend to be mature or — even worse — overvalued.
Check out what happened during the dotcom bubble of the late ’90s. Lots of stocks surged, generating huge paper profits for its investors. But the economy wasn’t exactly growing as fast as the market. And one of the aims of the Dow is to provide a view of the U.S. economy. From Dow Jones:
“… the DJIA today serves the same purpose for which it was created – to provide a clear, straightforward view of the stock market and, by extension, the U.S. economy.”
The Dow may not have surged as much as the S&P during dotcom bubble, but it was much more successful at providing a view of the economy than the S&P. Furthermore, by having a Dow underweight tech stocks, the existance of a bubble was more visible. Here’s a chart of the Dow against the S&P 500.
Photo: St. Louis Fed / FRED
Yes, The Dow Has Problems
To be clear, the Dow isn’t perfect either. It is significantly biased because it’s a price-weighted (not market-cap-weighted) index of just 30 stocks, which are more or less picked arbitrarily.
“Price-weighted” means that stocks with the highest share prices have the most influence on the index’s movements. So, McDonald’s, which has a market cap of $98 billion and share price of $97, would have a larger impact on the Dow than ExxonMobil, which has a market cap of $404 billion and share price of $86.
How About Tweaking The Dow?
Bary doesn’t want the Dow to be the S&P.
Another solution would be to scrap the Dow’s price weighting entirely and move to a market-cap system like the S&P 500. That, however, would destroy one of the distinctive qualities of the Dow, and make it resemble the S&P 500.
But he suggests ways to change the Dow so that it could include the Apple, while limiting its distortive effects.
One solution would be to adjust the way the Dow is calculated, capping the weighting of any stock at a fixed percentage, say 10%, which would ease the way for Apple and Google to enter the DJIA.
There’s precedence for a capped weighting because the Nasdaq 100 index, the basis for the popular exchange-traded fund PowerShares QQQ Trust (QQQ), now limits the weight of any member to 24% after cutting Apple’s weighting to 12% from 20% in a surprise special rebalancing last year. A 10% Dow cap could also limit the already sizable impact of IBM, if the index’s guardians want to apply a threshold to existing components. If Apple’s weighting were capped, only part of its daily moves would be reflected in the Dow.
However, a weighting limit is pretty arbitrary. It’s almost as arbitrary as the fact that the Dow is price-weighted. What if someday there is a company out there that controls 20% of the economy?
By introducing limits, the index will be made much more confusing and would likely offer less useful information about the markets and the economy.
If Apple’s In, Who’s Out?
For the sake of argument, let’s assume Apple is added to the Dow 30. Then who’d be out?
Bary identifies three stocks that could come out: Alcoa, Bank of America, and Hewlett-Packard. From Bary’s story:
Alcoa probably would be the first to go because its $11 billion market value makes it the smallest stock, by far, in the average. And given its price around $10, it has very little impact on the Dow. A 50% move in Alcoa would push the index up by just 38 points.
Unfortunately, Bary doesn’t offer any defence of Alcoa, which is one of the most important bellwethers of the global economy. Alcoa is the largest producer of aluminium, the commodity most sensitive to the global economy. Here’s a chart from Citigroup:
It would be an awful shame to lose Alcoa from the Dow. Without it, you would have an even less accurate view of the economy.
All Of This Dow Bashing Is Silly And Shortsighted
It’s unbelievably tricky to provide a view of the stock market because there are a lot of stocks and there are a lot of things going on in the market.
We’re not trying to argue that one index is better than the other or that there should be one all-encompassing type of index.
The argument for tweaking the Dow may have some merit. But ultimately, you end up with another index that has flaws and biases.
We think that the Dow has plenty to offer as is. And so does the S&P 500. By understanding the biases of each index, one can get a more accurate and comprehensive read on the markets and the economy by looking at the various indices side-by-side.
It’s the differences in the indices that cause the divergences, and that in turn is what makes them great.
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