'Apple-Less Dow' Is A Good Thing

| About: SPDR Dow (DIA)

An article titled "Apple-less Dow faces changes to make-up," found in the Financial Times, suggests that the current owners responsible for the composition of the Dow Jones Industrial Average (NYSEARCA:DIA) are considering ways to make it possible to add Apple (NASDAQ:AAPL) to the 116-year old index. The myopic view of changing the Dow Industrials simply for the purpose of adding Apple will haunt the index managers and investors alike.

In the past, the changes in the composition of the Dow have been ill-timed to begin with. In our article titled "Dow Jones' Decline Largely Impacted by Index Changes," we highlight the fact that composition changes routinely impacted the Dow Industrials negatively. Additionally, we have demonstrated that the changes to the Dow Industrials from 1929 to 1932 were the sole contributor to the decline of the index by -89%, when compared to the Barron's 50 Index in the same time frame.

In a follow-up article titled "Recovery From 1929 Crash Was Quicker Than Most People Think," we show how the irresponsible changes to the Dow Industrials from 1929 to 1932 was the reason the index took 25 years to get back to break even.

We've shown that many high quality stocks (the purpose of the Dow Industrials is to represent "high quality") were able to reach their 1929 high in 8-9 years instead of 25 years like with the Dow Industrials (as reflected in the Monsanto (NYSE:MON) chart below). The extended delay in getting back to the prior high was due solely to a losing trader's mentality of "buying high and selling low" applied to additions and subtractions to the Dow Industrials.

The recent addition of Unitedhealth Group (NYSE:UNH) to the Dow Industrial Average, replacing Kraft Foods (KFT), exemplifies the "buy high, sell low" mentality of those who manage the index. Unitedhealth is being added after nearly 215% gain in the stock since the March 2009 low. This compares to "only" a 100% gain in Kraft Foods since the same starting point, see chart below.

To emphasize our point, since the March 9, 2009 low, the following are the major index returns:

  • NYSE Composite (NYSEARCA:NYC): +98.22%
  • Dow Industrials : +107.41%
  • S&P 500 (NYSEARCA:SPY): +115.98%
  • Dow Transports (NYSEARCA:IYT): +128.74%
  • Russell 2000 (NYSEARCA:IWM): +149.23%
  • Nasdaq Composite (NASDAQ:ONEQ): +150.66%

As the theory goes, the performance of a well diversified index should achieve moderate gains and moderate declines. The DJIA has performed as though it was a well diversified index, rather than one composed of only 30 companies.

On the flip side of the diversification theory, a highly concentrated portfolio should have higher volatility both up and down. For a sense of perspective, the Russell 2000 does not contain Apple, while the Nasdaq Composite does. The absence of Apple in the Russell index did not inhibit its ability to effectively match the performance of the Nasdaq Composite.

With the S&P 500 having AAPL as part of the highest composition of a single company in the index, the +115.98% gain is a paltry difference compared to the current consistency of the Dow Industrials without AAPL.

As we've pointed out in our article titled "Broader Market And Dow Theory Suggest Proceeding With Caution," if the Value Line Geometric Index is any indication, broad participation of the rise from 2009 is faltering (see chart below).

This lack of broad participation is a warning that the narrow focus on a few companies at the top (based strictly on market cap) is going to collapse upon itself or more focus on values not related to the largest cap stocks is necessary. Market history suggests that broad-based equal-weighted indexes that don't make new highs are the canary in the coal mine. Anyone seeking Apple's inclusion to the Dow Industrials is fated to repeat the mistakes of the past, with unsurprising outcomes to follow.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.