Why is Dow Jones Misleading

Why is Dow Jones Misleading

Dow Jones is one of the most common global equity indices, dating back to the mid-1880s as a daily newsletter and 1896 as a Dow Jones Industrial Average.

The S&P 500 was launched in 1957 and the more advanced NASDAQ in 1971.

But as a reference point, the Dow Jones is radically different. Instead of a market capitalization-weighted index, the Dow Jones is price-weighted.

In other words, the valuations of the S&P 500 and NASDAQ are weighted on the basis of the value of the company (value meaning market cap).

This is a better way of doing things to ensure a fair reflection of their economic performance compared to the index as a whole.

In other words, if you take the market cap of one company and divide all the market caps of all the companies in the index by one stock, you will get its same weighting. The sum of all relative weightings is the value of the index.

However, the Dow Jones is uniquely weighted on the basis of the share price.

In other words, if a company divides its stock by 10-to-1, its weighting in the index would decrease by a factor of 10.

Splitting a stock has little to do with the valuation of a company. It essentially splits the public ownership of the company into more manageable fractions.

In general, stock splits are performed to further diversify the shareholder base. When the stock is $100 instead of $1,000 per share, it becomes more accessible for more retail investors (even in an age of widespread fractional share trading).

It makes it more liquid, too. More shares can be exchanged on a regular basis at a lower per-share price.

On August 31, 2020, Apple divided its stock 4-to-1. This has no effect on the valuation of Apple. But in the 30-stock Dow index, the stock will switch from the highest-weighted business in the index to the 16th highest-weighted. (The S&P 500 will be the most weighted.)

This means that Apple can no longer drive the index as much as it does, and the Dow will need to focus more on other firms. At the time of its breakup, it was over 50% year-to-date.

IBM’s unusual historical effect on Dow’s valuation

Apple’s lower contribution to the Dow forward is likely to reflect a drop in the bucket relative to IBM’s exclusion and later re-inclusion.

In 1939, IBM was excluded from the Dow to make room for the telecommunications giant AT&T.

It was re-entered in June 1979 to replace the failing Chrysler.

Over those 40 years, the Dow rose from 151 to 841, or a return of 5.6x (4.4 percent annualized).

If IBM had not been replaced, the index would have risen to 23,580, or a return of 156x (13.4% annualized).

It did not cross 23,580 standards until 38 years later in 2017.

Without the peculiarity of IBM’s temporary absence, the Dow, with an annualized return of 8.8% since then, would have been worth around 770,000. One thousand-point changes will be a mere 0.01 percent change rather than a 3-4 percent change today.

Other Stock Splits Impacts on Dow Jones

Due to the price-weighted structure of the Dow, the division of shares will change the sectoral composition of the index.

Apple’s stock split diminished the tech representation of Dow. Stock indexes are generally considered to be the barometer of the economy as a whole. Consequently, the committees in charge of them want the sectoral weights to stay approximately on average over time.

With Apple’s stock split, that meant that the tech weight of the Dow was dramatically reduced and the index had to reshape its components.

The Exxon Mobil Oil Conglomerate (XOM), the longest-running of the 30 Dow companies, was thrown out of the index. Drugmaker Pfizer (PFE) and security firm Raytheon Technologies (RTX) were also excluded.

Salesforce.com (CRM) software vendor has been brought in. Honeywell International (HON) and the pharmaceutical corporation Amgen (AMGN) have both issued a node for inclusion.

Because of passive cash-associated flows into Dow Jones-related ETFs and futures contracts, changes had an effect on the share price of each firm.

Exxon lost 3.2 percent, while Pfizer and Raytheon lost 1.1 percent and 1.5 percent respectively.

Salesforce.com earned 3.6 percent while Honeywell and Amgen earned 3.2 percent and 5.4 percent respectively.