Tuesday, February 24, 2009

Reuters: Is it Time to Overhaul the Dow?

If you follow the blog for any period of time you will see I almost never reference the Dow Jones Industrial Average; instead focusing on the broader S&P 500. The Dow is only 30 stocks and unlike most logical indexes is price weighted; which means a stock that trades at $80 is 8x more important than one that trades at $10. If the Dow was equal weighted - the demolition of Bank of America (BAC) and Citigroup (C) would have had a much larger effect.

An interesting take, via Reuters on the need for overhaul.
  • There was a time when a tumble below $10 in the share price of a company in the Dow Jones industrial average (DJI:^DJI - News) meant ignominy. Now, after vertiginous stock market falls in recent months, five of the venerable index's 30 components are trading under that price, including its two oldest members, conglomerate General Electric (NYSE:GE - News) and automaker General Motors (NYSE:GM - News).
  • Citigroup (NYSE:C - News) stock plunged below $2 on Friday, making it cheaper than a medium cup of coffee at Starbucks. Continued membership in the Dow of these battered stocks, which include aluminum producer Alcoa (NYSE:AA - News) and Bank of America (NYSE:BAC - News), is raising questions over whether the index should overhaul its lineup to include the likes of bank Goldman Sachs (NYSE:GS - News) or Internet company Google (NasdaqGS:GOOG - News).
  • It has also stoked a decades-old debate over whether the 112-year-old index is really an accurate snapshot of the overall U.S. economy. "It's been out of touch for a while," said Jocelynn Drake, an equities analyst at Schaeffer's Investment Research. "There are companies out there that are more significant to the market and they have not appeared in the Dow and there are others that should have been kicked out."
  • Financial journalist Charles Dow created the index in 1896 to help investors track market trends in the absence of other metrics. Most investors, however, now use broader indexes such as the S&P 500 (^SPX - News) to follow stocks. Still, the Dow is the most widely watched measure of the U.S. stock market and its members are considered an elite fraternity representing the best names in corporate America. (errr, not so much)
  • The index is rarely altered but when it is, it is done so at the discretion of a team of editors at The Wall Street Journal. It was last changed in September when food company Kraft Foods (NYSE:KFT - News) replaced American International Group (NYSE:AIG - News) after the U.S. government took a large stake in the insurer.
  • Citigroup and Bank of America should be swapped for a financial company with a higher share price, such as insurer The Travelers Co (NYSE:TRV - News) or Goldman, said James Bianco, chief executive officer of Bianco Research Securities. This would paint a more accurate picture of the financial sector because the Dow is a price-weighted index, where cheaper stocks count for less. For every $1 lost on a Dow component's stock price, the index sheds roughly 8 points.
  • That means if the three current cheapest stocks -- Citigroup, Bank of America and GM -- shrank to zero, the Dow would lose less than 60 points or 0.8 percent based on Friday's close, a sign of how much the sector has declined.
And that last point highlights why the DJIA is a poorly constructed index.

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