Limitations of Dow

When I was reading an article about “Why Google and its $1,000 shares will never crack the Dow”, in Bloomberg business certain thoughts came to my mind, so thought of writing about them.

Often people look at the stock index as it is perceived to be broad representation of overall stock market. Dow Jones Industrial Average is one of the three main indices of U.S. (other two being NASDAQ and S&P 500) and it is the oldest of three. Even though “industrial” word is there in the name of the index, Dow now include non-industrial companies also as over a period of time economic composition of sectors changed. Present constituents and their weights of the Dow are as follows (Source Bloomberg and data is as of 21^st October).

Though Dow changed its constituents of the index over a period of time, but it didn’t change the calculation method of the index. It follows price-weighted index calculation method wherein stock price will decide the index proportion i.e. highest weighting will be given to a highest stock price and vice-versa.

There are certain limitations of this method. For example as mentioned in the above article, it becomes difficult to include a stock in the index if its price is too high as is in the case of Google or Apple. Even though both of these companies are technology sector giants it is difficult for Dow management to include these companies as these companies’ stock prices are substantially high as compared to Dow components’ stock prices. For instance Google trading at $1000+ and Apple at $500+ will fetch almost half of Dow index weighting if included at these present price levels. So because of high price these companies can’t be included in the index calculation.

Second limitation is price of a stock does not represent the size of the company. To be precise, price of the stocks doesn’t reveal the companies’ position in their sector or overall market. For example Visa is a highest-weighted stock in the Dow because of its share value, which is highest among its components. But revenue wise Visa is smallest company (around $11 billion) whereas JP Morgan whose revenue is almost $100 billion (9 times of Visa’s revenue) is at 21^st position in price-weighted stock in the index. Chevron, whose revenue is less than half of the Exxon Mobil, influence Dow more than Exxon as it is the 6^th highest weighted and latter being at 10^th position.

Third limitation or complicated situation is of corporate action. Corporate action may be stock split or reverse split or bonus share issuance. Companies can split their stock prices for various reasons into smaller priced ones by any ratio. Reverse split is nothing but opposite action of stock split, wherein companies merge their stock. Bonus share means companies issues shares in certain ratios for existing share holders. For all above actions stock price will be forced to adjust. So according price-weighting index method company’s position will be changed even though not much change happened to company except its share price.

Fourth would be question of index representing all the shares in it. In price-weighted index it may or may not give due importance to all companies' share, which it has. Means if divergence between heavy and low weighted stock prices increases then index may move in either direction just because of heavily-weighted stocks rather all stock prices in it! For example in above case if Visa, IBM, Goldman Sachs and other top companies share price increases and GE, Intel and Cisco price decreases or remains constant over a period of time then latter ones lose on their weight and earlier ones gain on their weight. If this persists for a long period of time then Dow will majorly move by the top weighted companies. This means index value may not represent exact status quo of its constituents itself! These results in a situation like index regaining its lost value but most companies' stock value still at abysmal level!