The Changes to the Dow: Goodbye GM and Citi, Hello Cisco and Travelers

As most readers will notice, I rarely if ever talk about the Dow Jones Industrial Average (DJIA). There are a few reasons - mostly it is only 30 stocks and the way it calculates price changes is nonsensical. Unlike most indexes, the DJIA is price weighted, meaning a stock at $80 would have 10x the impact of a stock at $8. So in theory you could have 29 stocks trading at $10 and 1 stock trading at $300 and the $300 stock would be the majority of the daily movement. Hence, Google (GOOG) has no chance of being included in the DJIA! On the flip side when low-price stocks go into freefall it doesn't affect the DJIA much. Citigroup (C) going from $8 to $1 didn't do much damage.

Here are the changes to the index. For such a staid index, it is remarkable to think that 3 companies have been replaced in just the past 12 months (10% of the representation) and 5 in under 2 years. But we live in remarkable times, don't we? I think at 20% technology is overweighted in the DJIA, so adding Cisco Systems (CSCO) doesn't make too much sense in terms of how our economy is reflected. Travelers (TRV) does make sense as it's a more conservatively run large insurer, but I thought Visa (V) would have been an excellent choice. To better reflect our society, however, either a bubble maker or paper printing operation would have been the best choice. Or at minimum, yet another retailer - after all, consuming is 70% of the economy.

Via Bloomberg (emphasis mine; my comments in italics)

• General Motors Corp. and Citigroup Inc. (C), crippled by the first global recession since World War II, were removed from the Dow Jones Industrial Average and replaced by Cisco Systems Inc. and Travelers Cos. GM, which filed for bankruptcy protection today, and Citigroup, the recipient of $45 billion in taxpayer aid, became the first companies since American International Group Inc. in September to leave the 30-stock average. Their shares have lost more than 90 percent since the start of 2007.
• By replacing GM with Cisco, Dow Jones & Co. has removed automakers from the best-known benchmark for U.S. stocks, saying in an e-mailed statement that computers are as central to the economy as cars were in the previous century.
• Citigroup, until last year the world’s biggest financial firm by assets, is being replaced by a company it jettisoned in 2002 and that was once run by its former chairman, Sanford “Sandy” Weill. (Isn't that ironic?) Citigroup was formed in 1998 from the merger of Travelers Group Inc. and Citicorp. In 2002, Citigroup gave up control of Hartford, Connecticut-based Travelers Property Casualty Corp. through an initial public offering and subsequent spinoff.
• “This announcement brings front and center the challenges facing the U.S. economy as it strives to remain competitive,” said Alan Gayle, director of asset allocation at Ridgeworth Investments, which manages $60 billion in Richmond, Virginia. “The Dow Jones Industrial Average is becoming less of an industrial average. It’s trying to reflect the broader economy.”
• Thomson said Citigroup may be considered for the index again after it has “refashioned itself,” according to the statement.
• Travelers, the second-biggest U.S. commercial insurer, joins JPMorgan Chase & Co. (JPM), American Express Co. (AXP) and Bank of America Corp. (BAC) among financial companies in the Dow. Its higher price than Citigroup’s will boost the benchmark’s financial weighting from about 7 percent. (That is also ironic in terms of a small weighting considering financial industry profits were the lion's share of US profit growth in the 2000s.)
• Cisco, the world’s largest maker of computer-networking equipment, joins Microsoft Corp. (MSFT), International Business Machines Corp. (IBM), Intel Corp. (INTC) and Hewlett-Packard Co. (HPC) in the Dow, boosting its technology weighting from about 17 percent. With the addition of Cisco, computer companies will surpass industrials including 3M Co. (MMM) as the biggest category in the average. (Shouldn't we rename it the Dow Jones Technology Index if that's the case?)
• Kraft Foods Inc. (KFT) was named to replace AIG (AIG) in the Dow average on Sept. 18, the day after the nation’s biggest insurer was taken over by the U.S. government to avert its collapse.
• Three companies left the Dow last year, including AIG. Altria Group Inc. (MO) and Honeywell International Inc. (HON) were replaced by Bank of America and Chevron Corp. (CVX). Those changes were the first since 2004.

Comments

[Graham and ...:]

Travellers is to Citigroup what Kraft was to the old Philip Morris, hence a like-for-like replacement.

Jun 01 03:41 PM

[Lightway:]

Cisco may not make sense from a weighting standpoint, but as a company that represents the wider economy, it was a perfect choice. Most data centers use Cisco equipment, and anyone reading SeekingAlpha at the moment, the odds that your internet traffic is passing through a Cisco device, is 100%. Cisco is the equivalent of the national (international) freeway system, linking up the servers that run the internet, and desktops that connect to them.

Business schools and current economic commentary has been preaching that the US economy has been moving from a manufacturing-based economy, then to a services-based economy, and now to an information-based one. This selection seems to be a reflection of that.

Jun 01 04:04 PM

[stockfan:]

Cisco is about as "industrial" as you can get when it comes to making the backbone of the Internet and Corporate networks work. Complaining that an Industrial Index includes too much tech is missing the point. Even traditional "Industrial" companies like 3M are all about tech and innovation. It seems odd to differentiate types of tech and innovation on such narrow grounds. Industrial seems better applied as behind the scenes making things work as compared to point product consumer businesses. You actually argue for Visa in place of Cisco when Visa really isn't Industrial by your standards either. It looks apparent that DJ takes the broader view of what Industrial is which is just a sign of the times for the role of high-tech in our economy.

Jun 01 04:04 PM

[MrZack888:]

buying GM ( domestic) cars out of sheer "Patriotism" is same thing as communism. America was built on winner take all capitalistic competition. If it allows foreign cars to compete in its domestic market, then it's very capitalistic and true patriotism to buy the "efficient" , "reliable" foreign cars.

Jun 01 04:07 PM

[RiskReturnO...:]

I wonder how much of V stock value is based on the anticipation of being included in DJIA ... does anyone have a way of de-coupling this and seeing how much value is at risk for not being included ... CNBC and others have been talking a lot aout Visa being included, perhaps driving up the stock, so will the fast money now sell the stock to take profit??

Jun 01 04:12 PM

[dybydx:]

while i admit the dow's price weighted method and selection of 30 stock is rather peculiar, it does make up for this in its expert selection of stocks.

historical data shows that dow and s&p 500 is almost identical in the long run. the tracking error between dow and s&p is 0.18% per yr in the last 38 yrs. so dow is just a cheaper way to mimic the market than s&p.

this was useful before the days of Vanguard 500 became available, since buying the index require you to literally place 500 buy orders and incur ungodly amount of trading costs.

the advent of ETF made the difference moot.

Jun 01 04:41 PM

[Market Sniper:]

Oh boy. Now we have to dig around to find out how much Travelers' balance sheet is involved with toxic derivatives, how much of THAT is handled off balance sheet, etc. Sandy Weill was involved here, afterall. Not too hard to figure out they might be sitting on a ton of junk.

Jun 01 06:01 PM

[ps55:]

At least for all of us traders out there we know the market volatility is here to stay for a while! Plenty of opportunity out there

Jun 01 06:32 PM

[Hillsfar:]

SURVIVORSHIP BIAS
I'm surprised no one has mentioned Survivorship Bias in the Dow. We think the Dow keeps doing so well over the past 100 years, historically, mainly because the components that fail, get removed.

Jun 02 03:19 AM

[Ricard:]

I completely agree with the author's comments regarding the Dow as being nothing more than a signpost without a lot of utility.

However, about the 20% stacking of technology...I see nothing wrong with this. It reflects the *strength* of the US economy - we lead the world in tech, and that really does need to be reflected in financial markets, IMHO. What better statement to make than adding Cisco?

Jun 02 04:19 AM

[Uncle Pie:]

Isn't it funny how they wait till GM files Chapt. 11 before kicking it out of the indexes. That's not so much like closing the barn door after the horse has fled, but waiting till the horse has died of old age, as well. Why anyone would invest real money in an index fund that mimics the Dow or S&P index is beyond me!

Jun 02 09:16 AM

[Uncle Pie:]

Isn't it funny how they wait till GM has filed Chapt. 11 before kicking it out of the indexes. That's not like closing the barn door after the horse has fled, it's more like waiting till after the horse has died of old age before closing the barn door. Why anyone would invest real money in an index fund that mimics the Dow or S&P averages is beyond me!!

Jun 02 09:19 AM