Tuesday, September 10, 2013

Dubious Dow gets another arbitrary change

Today's news is an example of why I don't give a damn about the Dow.

The Dow Jones Industrial Average - a.k.a. the Dow 30 - is getting one of its periodic overhauls on September 23rd.  A committee has decided that Alcoa, Bank of America, and Hewlett-Packard will be replaced in the lineup by Goldman Sachs, Visa, and Nike.  Because the Dow is weighted by the price of one share rather than by the size of each company, the new components (share prices of $165, $185 and $67, respectively) are going to become instant heavyweights in the average relative to the shares they're replacing (priced at only $22, $14, and $8) and relative to the other 27 companies they're joining.  In other words, when the market opens on Monday the 23rd, there will be an index with the familiar "Dow" monicker, but it will not be the same index that closed on Friday the 20th.

This type of quantum change doesn't happen with the S&P 500 index.  Since membership in the S&P 500 is based in part on the size of a company (market cap) the rules for swapping companies into and out of the index are less arbitrary.  More to the point, the companies that participate in the shuffle are likely to be among the smallest companies in the index, because shrinking below the market cap requirement - or growing above it - gets one removed from- or can get one added to the index, respectively.  Since the S&P is weighted by the size of each company, these periodic changes down at the bottom have an insignificant effect on the overall index.  The evolution of the S&P 500 over time has thus been more gradual and organic than that of the Dow 30.

For assessing the current state of the U.S. stock market, the S&P 500 index is simply a more logical choice than the Dow 30.

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