With speculation that the government will either nationalize Bank of America (NYSE:BAC) and Citigroup (NYSE:C) or increase its stake in the banks, financial stocks have been hit pretty hard as of lately. With both banks trading in the single digits, investor confidence in their survival is pretty low.
Two other notable companies whose future appears uncertain are General Electric (NYSE:GE) and General Motors (NYSE:GM). The common thing between the two is that they are both also members of Dow Industrials and S&P 500 and both are trading in the single digits.
Before we understand why it matters that the four companies mentioned above trade in the single digits, it would be beneficial to understand how Dow Jones Industrials average is calculated.
The Dow Jones Industrial index is price-weighted. This gives relatively higher-priced stocks more influence over the average than their lower-priced counterparts, but takes no account of the relative size or market capitalisation of the components. To compensate for the effects of stock splits and other adjustments, it is currently a scaled average, not the actual average of the prices of its component stocks—the sum of the component prices is divided by a divisor, which changes whenever one of the component stocks has a stock split or stock dividend, to generate the value of the index.
Thus at the current market price of GE, GM, BAC and C, these stocks account for 1.82% of the Dow Jones Index. Thus, if these stocks all went to zero, anyone who owns a Dow Jones Industrials linked ETF or mutual fund won’t care that much. Even if the whole financial system went bankrupt, and all the financial components of Dow Jones Industrials went to zero, the index would lose 4.17% of its value.
In comparison to S&P 500, which is a market cap weighted index, if Bank of America, Citigroup, General Electric and General Motors all went to zero, the effect would not be much different. These stocks account for 2.01% of the weight in the broader US stock market index.