The Dow Jones Industrial Average needs all the help in its losing battle to keep up with the other 2 major stock indexes. Things are about to get even more challenging.
The Dow Jones Industrial Average, commonly known as just the Dow, is the grandfather of major stock indexes, going all the way back to 1896, to provide people with an easy reference to how the large companies that it tracks are doing, and presumably, the stock market in turn.
While it was designed to measure the progress of large industrial stocks, where it got its name from, its scope has broadened over the years to have representation across other major sectors as well, including the technology sector.
This was necessary in order for them to try to keep up with their younger but now much bigger brother, the S&P 500. The knock that people see with the Dow isn’t that it doesn’t represent the broad range of different sectors in the stock market anymore, they instead look at their having just 30 stocks and see less representation of the market as a whole based on how few stocks this index tracks.
That’s not the actual biggest knock on the Dow though, as it’s not how many stocks that they have that distinguishes it, it is how it weighs price movement. People read that the Dow is price weighted where the norm now is to use a market cap weighted calculation, but just knowing this doesn’t make the disadvantage of price weighting all that obvious. Seeing how Apple’s planned stock split will affect it does make this all easier to understand though.
Market capitalization weighting allows for the percentage change in a stock to affect an index proportionately, where if Apple goes up by 36%, its market capitalization has also gone up by that much. With a price weighted calculation, percentage gains don’t matter, as each dollar that a component’s price changes will produce a change of 6.859 Dow points, whether this be a small percentage gain or a large one.
Market capitalization therefore weighs stocks more by way of actual growth and not just stock price growth. Apple is the star of the Dow not just because it has gone up so much, as a lot of its disproportionate effect is due to its stock price is the largest in the index, and stock prices mean everything to the Dow. This is about to change dramatically though.
Stock splits have no effect on market cap weighted indexes, because the market cap doesn’t change when you split a stock. With the 4 to 1 stock split that Apple has announced, to happen in about a month from now, Apple’s stock price will be cut by a quarter but this will be offset by their having 4 times as many shares.
Market capitalization is calculated by multiplying the number of shares outstanding by a stock’s current price, so these things do not produce any change in the impact of a stock upon an index. With a price weighted index like the Dow, when you split a stock like this, its impact upon the index gets split as well, in proportion.
Both the Dow and the S&P 500 have benefited from Apple’s surging stock price, but with this impact about to be reduced by three quarters, the Dow won’t be able to rely on Apple anywhere near as much to help them compete with the S&P 500, who will now have the added advantage of counting Apple’s gains four times as much as the Dow will going forward.
The Dow has already been struggling enough in trying to keep up with the S&P 500 of late, underperforming it by 6% in 2019 and by 8% so far in 2020. It turns out that the impact of this stock split is pretty easy to calculate, as if this were the case throughout 2020, the Dow would be behind by a couple more percent, making the gap 10% instead of 8%.
That may not sound like that much, but a couple of percentage points of lost return can add up to quite a bit over the years, especially with your index fund in the red already as the Dow is, because this adds directly to how much you are behind and need to make up.
We also need to realize that the trend lately has been to see the gap widen between overperformers and underperformers, and we only need to look at how the various Dow components this year have done. Both the S&P 500 and the Dow have their share of terrible stocks, but crappy stocks play a bigger role in the Dow, while the leaders have stepped up more with the S&P 500, even to the point where people have really started to worry about the super-sized footprint the leading tech stocks have in the S&P 500.
It is healthy for an index to look to accentuate the positive and diminish the negative, whereas the Dow, by way of both its construction and its calculations, ends up underrepresenting the positive and overrepresenting the negative over time.
Looking at stock splits makes this all clearer, once we realize that stocks don’t split because they are doing badly, they do it because their price has risen so much, like Apple’s has. The good get punished this way in a price weighted scheme, like Apple stock is about to be.
Apple’s very impressive growth has it representing a larger and larger proportion of the S&P 500, where a percentage gain in it as it grows has it moving the index even more, but when this impact gets slashed instead, where Apple goes from a 10% weighting in the Dow to just 2.5% after the split, and it is now at 6% of the S&P 500 and climbing, combined with the fact that Apple and stocks like it are the only reason why the other two main indexes aren’t behind this year, this change is not a good one for the lagging Dow.
Apple plays an even bigger role in the Nasdaq, which also uses a market cap weighted calculation but focuses a lot more on growth stocks than the other two indexes do, and it’s not what the Nasdaq has in it as much as it is what it does not have, not being burdened with a lot of stocks that are simply doing terrible now.
This would not be anywhere near as meaningful if indexes were just indexes, if they just existed for information purposes only, as a handy guide to see how the stock market overall is doing, or the various combinations that an index chooses to represent the market are faring.
Indexes are Investments, and Need to Stand Up to Other Investing Strategies
People invest in these indexes though, so how they are constructed and how they perform matters a great deal more than this, where people are staking a lot of the future on this. If you invest in the Dow, and therefore have to bear a personal cost when the index gets devalued like it is about to be from this split, this is far from just trivia.
In addition to this issue, the fact that the Dow has so many stocks that already have been performing poorly and have taken an even bigger hit this year, the ones that the few good stocks in the Dow have served to keep things from becoming even worse, is a big impediment to its future prospects.
The bad stocks will be given an even higher weighting essentially, as although they won’t change and every dollar that they move will still impact the index by these 6.859 Dow points, more of these losses will be left to stand when they aren’t being offset by the good as much.
If we hold an index fund that tracks the Dow, we’re not only buying Apple and a few other stocks worth owning, we also get stuck with stocks that have gotten hammered by the selloff earlier in the year but are so unhealthy that they are still mired in the pit even after the massive recovery that stocks in general have seen since.
It’s not even that stocks in general have seen such a revival, as the average stock is down on the year, and the more your index is focused on growth stocks, the better it has done since. The Nasdaq is a lot more focused on growth and that’s why it is up by 24% on the year. The S&P 500 is a mixed bag and this index is basically flat. Bad stocks are over-represented on the Dow and that’s why it is so much further behind.
When we hold the Dow as an investment, we need to ask ourselves if we really want to be owning stocks that are still down so much this late in the game. The list of Dow stocks that are still sitting with double-digit losses so far this year looks like murders’ row, and it is Dow that they are murdering.
This includes stocks like Boeing (-50.3%), Exxon Mobil (-40%), Walgreens Boots Alliance (-31.1), JP Morgan Chase (-30.4), Chevron (-28.4), American Express (-24%), Dow (-23.8), Disney (-20%), Intel (-19.8), Travelers (-15.3%), 3M (-13.8), Coca-Cola (-13.8), Merck (-13,2), Goldman Sachs (-13.2). If we add IBM (-8.3), we now have the bottom half of this index with an average loss of 22% this year.
Some of these stocks may end up recovering a good part of these losses as the recovery continues, but when the S&P 500 has fully recovered from all this, and the Nasdaq has really prospered, and you are so behind both, having your bottom half lose 22% would be a big reason.
What We Don’t Own as Well as What We Do Own Determines Our Success
Success in investing is defined not just by what we own but what we do not own, and the prospect of having Apple offset these losses less should indeed be concerning. The best way to offset the losses of the bad stocks in an index is to just exclude them though, and while most investors don’t want to tinker with their investments at all and prefer just going with the whole Dow in this case, we should not wish to be this harmed from being so lazy.
An environment like we have seen this year has served to really separate the contenders from the pretenders, where whatever cream your index has in it has been given a great opportunity to separate itself from the pack, although with the Dow, this means few stocks indeed.
Aside from Apple (+37%), there are only two other Dow stocks that have put in double digit gains, Microsoft (29.3%) and Home Depot (21.9%). Few people would want to put all their Dow money in just three stocks, although they really owe it to themselves to ask why not and the answer may end up really surprising them if they can manage to just work this out a little.
For those who are reluctant to do this, who want both more stocks in their basket but also want a very simple plan, we could do something like picking the top half or the top 10 of this index based upon performance, although we probably should prefer to look at these stocks over a couple of years or more to allow us to be more confident in our selections.
The best approach though turns out to be to go with the very best, and when it comes to the Dow, we’re down to Apple and Microsoft. Home Depot has done well this year but overall is barely in the top half of this index, where Apple and Microsoft have led the way for a very long time.
In 2019, these were the top 2 stocks in the Dow, and the fact that they are again in 2020 is no accident. This is not to say that this always happens, and this is why we need to look further back than a year here, as we don’t want to be riding stocks that have had a good year last year but this ends up being an outlier. Top performance is not an outlier for either of these leading tech stocks and is instead the norm, and we want to account for both nearer trends like a year out and ones a little further out at least.
The best way to deal with Apple’s weighting in the Dow getting carved up this much is to simply take the control as far as how these stocks are weighted away from Mr. Dow’s archaic method, which both punishes good stocks when they split and also keep out ones like Amazon that don’t, and stocks priced this high could never be put in the Dow because they would overwhelm it by way of their huge stock prices.
If Amazon was a Dow component, this would turn the index into the Amazon index, as it would be worth more than the other components combined. We don’t necessarily want to just be going with the good stocks that have been selected and fit into the Dow, and Amazon is a good example of a stock we may wish to own anyway, in addition to several other similarly good choices to put with our Apple and Microsoft stock that are in the Dow now and spread our stock risk around more suitably.
These two are good enough to make our stable though, and we only like the real good stocks, the ones that can really deliver the goods that we want and everyone should want, return on investment. Return on investment plays a very central role when we run our businesses, but somehow, even though this is also the goal with investments, we pay precious little attention to it with our stocks.
People can still pick this smelly index as presented, but we at least owe it to ourselves to ask why we would ever want to. We may wish for greener pastures based upon just how much the Dow has underperformed lately, especially in comparison to the Nasdaq, but we can’t forget that we can just build our own index instead with very little skill and effort aside from realizing that stocks do differ in quality and these differences are becoming more and more pronounced over time, especially in this new economic frontier where some stocks have been able to deal with the worst so much better than others.
The biggest problem is that we don’t own our results, we instead pretend that this is all up to the market which we keep pouring our money into and crossing our fingers, and don’t even wonder how we could have done instead if we only realized that this is all up to us and our choices must at least be considered alongside others that may have done much better.
These people will probably not even notice or care about Apple’s coming diminution in the Dow, they just buy the brand, the Dow brand that is. They use so little diligence that they are not only happy buying a surprise bag, they don’t even bother looking inside. They certainly miss that they are the CEO of their own investing business, and are too afraid to even sit in the chair and do anything to help themselves. They need to at least try harder than not trying at all.