The Dow Committee Again Gets It Wrong

By ETFguide.com  OCT 29, 2013 2:55 PM

Recent Dow changes were made strictly due to the low price points of the three ousted components.

 


In early September it was announced that the Dow Jones Industrial Average (INDEXDJX:.DJI) would swap Bank of America (NYSE:BAC), Alcoa (NYSE:AA), and Hewlett-Packard (NYSE:HPQ) with Nike (NYSE:NKE), Goldman Sachs (NYSE:GS), and Visa (NYSE:V) under the guise that it was a "desire to diversify the sector and industry group representation of the index."

Is that really so? 

The real reason for the Dow Committee’s shift is all about increasing the Dow’s price, and they are already reaping what they sowed because the Dow’s price is lower than it otherwise would be if they didn’t change the Index around last month.

The Dow Committee’s bad timing is nothing new though.

The Real Reason for the Dow Changes

The Wall Street Journal recently did a study that puts the Dow Committee’s track record into numbers.

“Since 1929 through 2005, stocks deleted from the Dow gained an average of 173% over the next five years. New additions gained 65%.”

In our October, we took a detailed look at the history of the Dow Committee and noticed a few more interesting facts:

The committee waited to add tech stocks to the Dow until the late '90s (Hewlett-Packard in ’97, along with Microsoft (NASDAQGS:MSFT) and Intel (NASDAQGS:INTC) not until ‘99).  It added Pfizer (NYSE:PFE) just after the biotech bubble of the early 2000s.  It also added financial stocks leading up the financial crisis. (AIG (NYSE:AIG) in ’04 and Bank of America in early ’08).

Not exactly the greatest track record the committee has.

How the Change Affects the Dow

On September 23, the day the switch took effect, the Dow would have been higher by approximately $2,088 points if it had included Nike, Goldman Sachs, and Visa since the market lows of March 2009 instead of Bank of America, Alcoa, and Hewlett-Packard.

This means the Dow would be trading at approximately $17,600 today instead of $15,500, but that’s only if the Committee would have added these companies near the bottom. Now they add them only after an abnormally large rally, five years of age now.

The move will only turn out to be a smart one in hindsight if the markets continue their rally.

But no investment decision comes without risk, and the Dow’s committee is risking a continued rise in the Dow price at the expense of an increase risk in volatility to the index.

True Colors

We shouldn’t believe the commentary of this being about “diversifying the group” either.

What’s the valid reason there are now zero traditional banks since Bank of America was dropped, but for some reason we now have two investment banks in JPMorgan (NYSE:JPM) and Goldman and over 50% of the credit card industry in Visa and American Express (NYSE:AXP) in the Dow?

Why not Wells Fargo (NYSE:WFC) which is significantly larger than Goldman or a handful of other options which make more sense from an economic impact perspective?

Because, none of the fundamentals of the Dow’s makeup matters, as the real reason for the switch is all about the optics of getting the Dow’s price higher.

The table below is sorted by share price and should show you all there is to know about the reasons for why the Dow Committee dropped the three companies they did. Is there any question as to why the changes were made and also looking at the chart, which companies will likely be next on their “drop” list?

The Dow changes were made strictly due to the low price points of the three ousted components, but how does this show the true motives?

 

The Dow’s Quick Math

As a price weighted index, a one percent move on a higher priced stock such as Visa (1% is around $2.00) affects the Dow’s price much more than a 1% move in Alcoa (1% is around $0.09).  A 1% move higher in Visa raises the Dow 13 points whereas a 1% move higher in Alcoa raises the Dow less than two points.

Put another way, a 1% increase in Visa moves the Dow 8x more than the same move in Alcoa.  Similar ratios exist with the other two additions and subtractions.

The Dow Committee is simply playing games with the Dow to try to make it go higher by jumping on the market’s uptrend.  It has nothing to do with updating the representation or for fundamental reasons, and as it turns out, the Committee’s history shows us they more often than not make changes at the wrong times.

Ways to Trade It

Those who follow the Dow also now must deal with the consequences of a benchmark that has much more volatility now.  The Dow point swings work the same way on the way down as they do on the way up.

Since the Dow’s change in September, the Dow (NYSEARCA:DIA) was lower by 67 points three weeks later than it otherwise would be if it still had its three old components, so already the component changes are confirming the contrarian signal.

Not only is the Dow more volatile after the September shuffle, it also is underperforming the other major indices setting up a negative divergence.  Based on the history of the Dow changes the odds increase that the Dow will continue its underperformance.

Editor's note: This story by Chad Karnes originally appeared on ETFguide.com.

To read more from ETFguide, see:

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No positions in stocks mentioned.