New Stocks In The Dow Jones Industrials: Much Ado About Nothing

 |  Includes: AA, BAC, DIA, GS, HPQ, NKE, SPY, V
by: Gary Jakacky

Should investors be concerned that Dow Jones has kicked Hewlett-Packard (NYSE:HPQ), BankAmerica (NYSE:BAC), and Alcoa (NYSE:AA) out of the Industrial Average, replacing them with Visa (NYSE:V), Nike (NYSE:NKE) and Goldman Sachs (NYSE:GS)? I believe they should not.

When gauging their portfolio or investment performance, most people and analysts on Wall Street compare their returns with either the Dow Jones Industrial Average or the Standard and Poor's 500 index. (You can also use their Exchange Traded Funds, the SPDRs DIA or SPY, respectively.)

Sure, there are two major differences between the two market barometers. Most obvious? The Dow Industrials consists of a simple "average" of the price of 30 leading companies. (Standard and Poor's looks at 500 firms: much broader and more diversified).

(To be honest, the Dow is not quite an average like you learned back in 7th grade. If that were the case you'd add up the prices of the 30 companies and divide by 30. But because of stock splits, spinoffs, and substitutions over the years, the divisor for the Dow Jones Average has changed: it is now a lengthy decimal: specifically, 0.130216081. This small denominator explains how we get a Dow Jones Industrials figure like 15,000 when the typical share price in the average is $40 or $50 dollars a share.)

In contrast the S&P500, as its name implies, looks at a far larger and broader spectrum of companies.

Second, and less obvious? The S&P 500 is a capitalization weighted, or market value weighted, index. A behemoth oil company like Chevron (NYSE:CVX) carries a lot more weight in the S&P500 than a small oil company such as Murphy (NYSE:MUR). This reflects Standard and Poor's belief that investors are more likely to be concerned with large companies than with small ones. After all, there are many more stockholders (and employees!) in CVX than MUR.

Thus, when the S&P500 debuted in the postwar period it was viewed as a far more scientific and precise measure of stock market performance. Many observers expected the stodgy old "Dow 30" to go the way of the dinosaur. The latter was viewed as antiquated. Not "with" the "new economy." (Yes, we had a new economy in the early 1950s!)

Why has that not happened? Simple: despite all the differences between the two in terms of number of firms, methods of calculation, and so forth, they move together in percentage terms with surprisingly little disparity.

This is clear if you look at a longer-term chart of both Indexes. Have a look at the last 10 years. The plot below shows the S&P500 Index in black superimposed with the Dow Jones Industrial Average in light brown.

Click to enlarge


I can address two different periods:

  1. In the recovery from the tech crash in the early years of the previous decade, the S&P500 did significantly outperform the Dow for a few years. Here is an example where the "big companies," which carry a lot of weight in the S&P500, made a difference in how your portfolio would have performed then. Even so, by the bull market top in 2007, the Dow had fully caught up.
  2. In contrast, during the great Crash and bull market recovery since March of 2009, it is almost impossible to see any difference in performance, except for a very brief period in 2011.

What does this mean for investors? There are times when large-cap stocks (which dominate the S&P500) are strong performers. But over time periods of a decade or more the two indexes are remarkably similar. This has remained so even as the Dow has replaced numerous components (only one stock, GE, remains from the original Dow Jones Average as it was compiled in 1896). Since the late 1970s, Dow Jones has adjusted its components 19 times.

Obviously, investors who hold shares of DIA will automatically see changes in their holdings and their ETF will continue to track the Dow step for step.

At the same time, investors in other broad ETFs such as SPY or other index funds, should expect their own portfolios to continue to track the Dow closely as well. There is no need to rush out and dump quality holdings so that you mirror the Dow's new industry profile or risk profile.

Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.