Dow Jones Gets a Major Facelift

by Dan Burrows | September 10, 2013 11:27 am

Dow Jones Gets a Major Facelift

The Dow Jones Industrial Average is about to get a major overhaul, and if history is any guide, the blue-chip index will be a much stronger performer after the changes.

Nike (NKE[1]), Visa (V[2]) and Goldman Sachs (GS[3]) will be added to the august average of 30 blue-chip stocks, effective Monday, Sept. 23.

But to make room for the sneaker company, payments processor and investment bank, three other names have to get the boot — and they are big ones.

Bank of America (BAC[4]), the nation’s second-largest bank by assets, is getting kicked to the curb. So is aluminum giant Alcoa (AA[5]) and has-been PC and printer company Hewlett-Packard (HPQ[6]). (Alcoa, at least, was long overdue for exclusion[7], as we noted recently.)

The Dow has changed dramatically over time, but this is the biggest shakeup since 2004, which was the last time the average underwent a three-for-three switch.

Why the changes now? Well, for one thing, the benchmark S&P 500 (and pretty much every other equity index) is weighted by market capitalization. But the Dow is weighted by price — and that was a big part of the reason for the swap, S&P Dow Jones Indices said. From their press release:

“The index changes were prompted by the low stock price of the three companies slated for removal and the Index Committee’s desire to diversify the sector and industry group representation of the Index.”

But that doesn’t mean you should blindly buy the new Dow components. Yes, Nike, Visa and Goldman Sachs all traded higher on the news, but that’s not likely to last very long. Sure, a stock always gets a bump from index inclusion, but getting added to the Dow Jones vs. the S&P 500 is an apples-and-oranges comparison — one in which the apples are kind of bruised and mushy.

When a company gets added to the S&P 500, a jump in share price makes sense and should have at least some short- to medium-term legs. That’s because there are so many indexed mutual funds and exchange-traded funds tracking the benchmark equity index. There’s $1.6 trillion in assets tied to the S&P 500. All those tracking products have to buy shares in any stock added to the S&P 500. That creates demand, boosting the share price — and naturally traders try to front-run that demand.

The Dow, however, isn’t nearly as popular as the S&P 500 when it comes to tracking products. Only about $30 billion in assets are linked to the blue-chip index.

A quick example: The SPDR S&P 500 ETF (SPY[8]) has assets of $136 billion and does average daily volume of more than 120 million shares. The equivalent ETF for the Dow — the SPDR Dow Jones Industrial Average ETF (DIA[9]) — has less than $12 billion in assets and an average daily volume of just about 6 million shares.

When it comes to ETFs, index funds, futures and options, the S&P 500 gets all the action and assets. The Dow might be the headline index — the one regular folks reference when they talk about the stock market — but it’s not really relevant to professionals.

Besides, getting tapped for the blue-chip index hardly makes a stock a buy, either. Cisco Systems (CSCO[10]), for example, was added in the summer of 2009. Cut to today, and it’s lagging the broader market by about 60 percentage points since it became a Dow component.

And let’s not forget that history is littered with once-great names dumped from the Dow. Eastman Kodak (EKDKQ[11]), anyone?

What’s more interesting is how much better the Dow would have performed had NKE, V and GS replaced BAC, HPQ and AA a long time ago. Have a look at the chart we created using data from S&P Capital IQ:

GSVNKEDowChart Dow Jones Gets a Major Facelift[12]

A Dow with NKE, V and GS instead of BAC, HPQ and AA would have been in a much stronger bull market after the last crash. Indeed, if this three-for-three switch had gone into effect when stocks bottomed out in March 2009, the Dow would be at 16,645 today — 1,582 points, or about 10%, higher than its current level.

No, past performance is never indicative of future returns. But these latest changes do look good for the future trajectory of the headline index.

As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.

Endnotes:
  1. NKE: http://studio-5.financialcontent.com/investplace/quote?Symbol=NKE
  2. V: http://studio-5.financialcontent.com/investplace/quote?Symbol=V
  3. GS: http://studio-5.financialcontent.com/investplace/quote?Symbol=GS
  4. BAC: http://studio-5.financialcontent.com/investplace/quote?Symbol=BAC
  5. AA: http://studio-5.financialcontent.com/investplace/quote?Symbol=AA
  6. HPQ: http://studio-5.financialcontent.com/investplace/quote?Symbol=HPQ
  7. Alcoa, at least, was long overdue for exclusion: http://investorplace.com/2013/08/blue-chips-in-question-jnj-xom-msft-aapl-aa/
  8. SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY
  9. DIA: http://studio-5.financialcontent.com/investplace/quote?Symbol=DIA
  10. CSCO: http://studio-5.financialcontent.com/investplace/quote?Symbol=CSCO
  11. EKDKQ: http://studio-5.financialcontent.com/investplace/quote?Symbol=EKDKQ
  12. [Image]: http://investorplace.com/wp-content/uploads/2013/09/GSVNKEDowChart.jpg

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