Indexes Defined: The Dow vs. S&P 500

Posted by Eric Anderson on July 18, 2012

eric_f.jpegAfter the large moves that equities enjoyed during the first quarter, we had thought it likely that stocks would need to consolidate their gains for a period of time, which is basically what happened with most equities pulling back and taking a break during the past three months.  Specifically, during the second quarter the Dow Jones Industrial Average declined 1.8%,  the S&P 500 lost 2.8%, and the Russell 2000 gave up 3.5%, while the NASDAQ, which did the best in the first quarter, slipped 4.8%, and the MSCI EAFE retreated by 6.9%.  

The best performing areas of the market during the second quarter’s pullback were not surprisingly, the more defensive and income oriented Consumer Staples, Telecom, and Utility sectors, with gains of 2.9%, 14.1% and 6.5% respectively.  Of the ten S&P 500 sectors, only Energy has delivered negative returns so far in 2012.  The weakest sectors during the second quarter were generally those that did the best in the first quarter, as the Financials were down 6.8% in the second quarter but are up 13.7% year to date, Technology lost 6.7% in the quarter but is up 13.3% on the year, while Materials were down 4.2% in the quarter and are up 6.5% for the year.  Only Energy was down in the quarter and down 2.3% for the first half as the price of oil retreated from the $110 high water mark seen in late February / early March,  to the mid to low $80’s presently.  The pullback in crude allowed prices at the pump to decline on average 50 cents per gallon.

Why does IBM have almost 10 times the impact of GE?

Over the past several years there has been a growing discussion within the investment community as to whether the Dow Jones Industrial Average will be able to remain as relevant in the future as it has for the past 116 years. The Dow is an iconic and ubiquitous index and remains the most watched and reported-on gauge of market index, and all the evening news programs discuss the Dow when talking about the day’s stock market activity.  The index was created and founded by the publisher of the Wall Street Journal, Charles Dow, back in 1896.

At its start, The Dow Jones was comprised of the simple dollar average of the dozen companies that Charles Dow viewed as the titans of U.S. industry which he chose to track and monitor.  Twenty years later in 1916 the index expanded to 20 companies.  In 1928 it was enlarged to its current level of 30 members.  There have been 48 additions and deletions to the components of the index over its history. Only General Electric (GE) remains from the early members, added in 1907.

It has now been over three years since there have been any changes to the components of the Dow.  The most recent changes were instituted in 2009 when Travelers and Cisco replaced General Motors and Citigroup.  One year earlier Altria Group, Honeywell, and American International Group were dropped in favor of Chevron, Bank of America, and Kraft Foods.  It is worth noting that Dow’s selection committee will soon have to decide what to do when Kraft splits into two separate companies later this year, which will result in the surviving Kraft entity having a much lower market value than its current $70 billion level.  Kraft was added to the Dow after it was spun out of former parent Altria Group who itself was removed as a result of the spin.

The Dow’s basic problem today is that it is not market capitalization weighted, but instead, is still computed in the rather outdated manner of simply adding up each member’s share price and then multiplying by an adjusting variable (now 7.6), to get the current value of the index, presently at 12,724.  The use of the adjusting variable allows the value of the index to remain constant whenever one of the member components changes due to a stock split or stock dividend.

With the Dow being a share price driven index, this means that a one dollar change in value of any of the 30 members has the same effect on the Dow’s value, whether it is IBM which trades for $200 per share or Bank of America at $8.00 per share.  Therefore, another way to view the share price influence on the Dow is to consider that IBM and GE are relatively the same size based on their market capitalizations, shares outstanding time the stock price.  GE’s market value is $206 billion and IBM is $218 billion, yet IBM comprises 11% of the Dow versus GE’s 1.2%, which means that IBM has more than 9 times the influence on the Dow compared to GE.  As a result, the index is basically being overly influenced by its high priced members, and the day to day movements of its lower valued share price companies like BAC, Alcoa ($8), Cisco ($17), and GE ($20) have no real effect on the average anymore.  Moreover, the top 5 members of the Dow comprise more than one third of the total index value, while the bottom five only contribute 5% of the total.

The overriding problem for the Dow that has developed over time is that companies are no longer splitting their stock prices when they begin to reach the $75 to $100 dollar values as was once the case.  There are presently 47 stocks in the S&P 500 that trade in excess of $100 per share.  In fact, some companies believe it is sign of strength and take pride in having a share price that is multiple hundreds of dollars, like Apple ($600), Google ($572), Amazon ($215), etc.

According to data compiled by Bloomberg, the Dow’s 30 stocks account for 24% of the U.S. stock market value, versus the S&P 500, which represents 75%.  Despite this disparity, over time the two indexes have tracked one another fairly well with about a 90% correlation; however, depending on the type of market and the mood of investors, one index can certainly outperform the other over shorter periods.  For example, last year when the market worried over issues calling into question the growth potential of the domestic and overseas economies, larger more conservative stocks were preferred over smaller growth companies.  As a result the Dow’s total return in 2011 was 8.4% versus the S&P 500’s 2.1%.  However, in the first half of this year, the S&P 500 is ahead by 9.5% versus the Dow’s 6.8% gain.

Alcoa has not been a leading U.S. industrial company for years and its stock price has languished for decades, but given that the Dow still reflects the movement of the broad stock market, and that it moves directionally in line with the S&P 500, the Dow’s selection committee has shown itself slow to make changes to the index.  However, given the growing trend against stock splits and the almost zero relevance of the smaller five members of the Dow (GE, Pfizer, Alcoa, Bank of America, and Cisco), it would appear that something needs to be worked into the average’s calculation to prevent the committee from avoiding high priced companies for inclusion into the average.

Each of the Dow’s 30 stocks are also members of the S&P 500, but generally at much lower weightings.

  Recent Percentage of  
Company/Ticker  Price  Dow S&P   
IBM /IBM $205.58 11.59% 1.79%  
Chevron /CVX 106.22 6.10 1.57  
Caterpillar /CAT 104.39 6.00 0.51  
McDonald’s /MCD 95.83 5.57 0.75  
3M /MMM 89.32 5.08 0.46  
ExxonMobil /XOM 86.07 4.95 2.99  
United Tech /UTX 81.25 4.71 0.55  
Boeing /BA 76.99 4.40 0.41  
Coca-Cola /KO 75.71 4.31 1.23  
Procter & Gamble /PG 66.87 3.92 1.37  
Travelers Cos /TRV 64.77 3.70 0.17  
Johnson & Johnson /JNJ 64.75 3.70 1.34  
American Express /AXP 59.59 3.40 0.52  
Wal-Mart Stores /WMT 58.95 3.40 1.53  
DuPont /DD 53.74 3.06 0.37  
Home Depot /HD 51.87 2.99 0.56  
JPMorgan Chase /JPM 43.80 2.48 1.27  
Walt Disney /DIS 43.36 2.46 0.57  
Verizon /VZ 40.14 2.30 0.81  
Kraft Foods /KFT 39.00 2.24 0.50  
Merck /MRK 38.47 2.20 0.87  
AT&T /T 32.44 1.90 1.38  
Microsoft /MSFT 32.11 1.88 1.98  
Intel /INTC 28.22 1.60 1.04  
Hewlett-Packard /HPQ 24.87 1.42 0.34  
Pfizer /PFE 23.06 1.31 1.26  
General Electric /GE 19.62 1.12 1.56  
Cisco Systems /CSCO 19.60 1.10 0.83  
Alcoa /AA 9.86 0.56 0.08  
Bank of America /BAC 8.27 0.49 0.75  

Source: Bloomberg, Dow Jones & Co., Barron’s