Why the Dow Jones Almost Certainly Will Continue to Underperform

The Dow Jones gets a lot of hype but it's not the best index for investors

dow jones

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It’s been a good year for the Dow Jones Industrial Average. The Dow as of this writing closed at 25,053.11, up 7.4% so far this year. The DJI already has erased a 3.5% decline in 2018 and perhaps could challenge all-time highs near 27,000.

But a good year for the DJI actually has been a better year for most other major indices. The S&P 500 has risen 8.1%. The NASDAQ Composite has gained more than 10%. And the Russell 2000 has increased over 12%, its best year since 1987.

As I’ve written in the past, the Dow Jones Industrial Average gets too much attention. With only 30 mega-cap stocks in the index, the DJI doesn’t reflect the broader market or the broader economy the way many observers (including the president) seem to believe.

Even that aside, the Dow’s underperformance this year isn’t new. Returns in the S&P 500 have been stronger in five of the last seven years. The NASDAQ Composite, thanks at least in part to a more tech-heavy nature, has been the better bet every year in that stretch save for 2016.

That trend could continue going forward. Component changes in the DJI may not be favorable. The index still favors old-line industrials, which have risks from both the macro cycle and tariffs. Given the fact that the Dow Jones today still dominates the headlines, that may not be a good thing for U.S. stocks as a whole.

The DJI so Far This Year

What’s interesting about the lower gains in the Dow this year is that the index seemingly should be doing better. Oddly, the index is price-weighted: the individual contribution of each of the 30 stocks is based not on their respective market caps, but their stock prices. And the higher-priced stocks have been among the strongest performers.

Most notably, Boeing (NYSE:BA) continues to gain, rising over 25% in 2019 alone. That is the highest-priced stock in the index – meaning it makes the biggest contribution. Goldman Sachs (NYSE:GS) has the fourth-highest price and is up almost 15%.

And it’s not like there’s any dead weight, at least so far. Only five stocks in the DJI are in the red for the year. The worst stock in the index, Pfizer (NYSE:PFE), is down just 4.5%.

Still, Dow stocks on the whole are lagging. And in a bull market, the larger stocks in the index are likely to underperform. Somewhat ironically, the stock kicked out of the index last year, General Electric (NYSE:GE), has had a huge start to the year. GE stock is up 32%; Walgreens Boots Alliance (NASDAQ:WBA), which replaced it, has gained just 0.5%.

Today’s Dow Is Not the Dow of 2020

More changes are coming. United Technologies (NYSE:UTX) and DowDuPont (NYSE:DWDP) both are breaking up. Those splits likely will lead to their removal from the Dow Jones.

The list of their potential replacements, however, somewhat highlights the longer-term problem with the DJI. The most obvious candidates are Amazon.com (NASDAQ:AMZN) and Alphabet (NASDAQ:GOOG,GOOGL). But both stocks have share prices that are too high; AMZN, for instance, would have nearly 40 times the impact on the index of PFE.

And so the DJI basically can’t include the third and fourth most valuable companies in the U.S., solely because of its structure. Though it should be mentioned that that could change if either company decides to split its stock.

The Dow also can’t add to its tech exposure: the most likely candidate on that front would be Oracle (NYSE:ORCL), but that low-growth company hardly gives exposure to the sector’s potential.

In this time of indexing, the Dow Jones simply doesn’t look up to the task. And with still-substantial exposure to older, slowing-growing mega-caps, it’s unlikely to capture the economy’s strongest sectors, most notably technology.

Will the Dow Fade?

Given the price-weighted nature of the index and the small number of constituents, it’s surprising the DJIA has maintained its status for as long as it has. Simply put, there are many better indices out there.

For that reason, investors to measure their returns should look beyond the Dow Jones Industrial Average. Investors looking to grow those returns perhaps should look elsewhere as well.

As of this writing, Vince Martin has no positions in any securities mentioned.


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