Apple Joins Dow Jones but Who Cares?

Apple will join the Dow Jones Industrial Average (DJIA) on March 19, replacing telecommunications giant AT&T, according to S&P Dow Jones Indices – the subsidiary of McGraw Hill Financial Inc. that owns the Dow Jones.

The addition is a historic event, as Apple gains entry to an extremely exclusive club. Yet even though the DJIA is well-known and remains the most followed stock market index, it is also one of the most inaccurate and distorted.

What Is an Index?

A stock market index is an group of selected stocks that attempts to describe the market according to the index’s goals. For example, the S&P 500 is an index made up of 500 of the most widely traded stocks in the U.S. and makes up about 70% of the total value of the overall U.S. stock market.

The Original Dow

The Dow, as it is simply known, is a stock market index created by Dow Jones & Company co-founder Charles Dow in 1896. At its conception, it consisted of just 12 stocks. They were:

American Cotton Oil Company
American Sugar Company
American Tobacco Company
Chicago Gas Company
Distilling & Cattle Feeding Company
General Electric
Laclede Gas Company
National Lead Company
North American Company
Tennessee Coal, Iron and Railroad Company
U.S. Leather Company
United States Rubber Company

These 12 companies were purely industrial stocks, and only General Electric is still part of the Dow – the rest either defunct or removed over the last 112 years. Today, it is an index of 30 blue-chip stocks, companies with a reputation for quality, reliability and consistency; it shows how 30 publically traded companies have traded during a regular stock market day.

The Dow Today

CompanyStock Market TickerMarket Cap (Billions)
3MMMM103.3
American ExpressAXP82.2
AT&TT170
BoeingBA106.8
CaterpillarCAT48
ChevronCVX191
Cisco SystemsCSCO142.6
Coca-ColaKO174.4
DuPontDD72.9
ExxonMobilXOM351.8
General ElectricGE252.1
Goldman SachsGS82.5
Home DepotHD151.3
IntelINTC146.5
IBMIBM152.5
Johnson & JohnsonJNJ275.9
JP Morgan ChaseJPM227.4
McDonald’sMCD92.6
MerckMRK159.5
MicrosoftMSFT339.5
NikeNKE82.8
PfizerPFE208.8
Procter & GamblePG221
TravelersTRV34.3
UnitedHealth GroupUNH109.9
United TechnologiesUTX107.7
VerizonVZ198.9
VisaV162.7
Wal-MartWMT264
Walt DisneyDIS180.9

Why the Dow Is Useless

Despite its popularity the Dow has many weaknesses as a benchmark for the overall U.S. stock market. The above 30 companies represent just a quarter of the entire U.S. market. There are over 10,000 companies in the overall market, and a one-percent change in the Dow does not equal a one-percent change in the entire market. This has to do with the way the index is put together.

The Dow Jones is constructed using a price-weighted function rather than using a market cap weighting. That means if two stocks are the same price, say $100, then a 1% change in either stock will have the same effect on the Dow regardless of the size of the stock – even if the company is Apple, with a market cap of $700 billion, or Caterpillar with a market cap of just $48 billion.

dow1

Source: The Walt Disney Company

Basically a Dow component with a high stock price can cause significant changes in the index with smaller moves than can a Dow component with a low stock price. A $100 stock will have 10x the weight of a $10 stock.

As of today, Goldman Sachs ($192) and Visa ($270) have the highest priced stocks in the Dow and as a result wield the most influence on it. Imagine if Warren Buffet’s Berkshire Hathaway were included! (Current share price: $219,502)

The other problem is that the DJIA is a fluctuating index in its construction. In 1896 the index consisted of 12 companies. In 1916 that number rose to 20 and then again to 30 in 1928. That number has stayed constant for the last 87 years but since then the component companies have been changed more than 50 times. This makes it hard to compare the performance of the index over time.

Not Enough Tech

Finally, the index is not representative of the true economy. As it stands the Dow has four true-blue tech companies. They are Cisco, IBM, Intel and Microsoft – which together account for 10% of the Dow index. On the other hand, the tech sector is one-fifth of the overall market (as measured by the S&P 500).

If you consider that the National Science Foundation cites data that “technology-intensive” industries contribute 40% of U.S.  GDP then we begin to see how the Dow grossly undervalues the tech sector. If the Dow is attempting to be a facsimile of the U.S. market then it is definitely falling short.

So What About Apple?

The inclusion of Apple could make the Dow more vulnerable to sharp moves. The index generally is made up of more-mature, less-volatile companies and Apple’s shares have nearly double the volatility of AT&T’s.

At the same time, Apple has cemented its status as a blue-chip stock.  The Dow is known as an index of blue-chip stocks and Apple’s entry is proof enough of its reliability for many stock market trackers and analysts.

What we can now expect is a price increase for the MacBook and iPhone maker. In the past, studies have shown that being added to indices such as the S&P500 have resulted in gains in the company’s stock price. This happened mainly due to a rise in purchases of the stock by index funds and ETFs tracking the index. Remember, you can’t invest directly in an index like the Dow Jones; you have to invest obliquely through an ETF. This is unlikely to happen with the Dow because the funds that track it are much smaller than the ones that track an index like the S&P 500. The smaller the amount of money going around and thus the smaller the total purchase, the less effect there will be on a stock as large as Apple.

What about the Dow?

The Dow Jones chugs on. The market shifts and changes the Dow adapts, reflecting the changing face of U.S. blue chip stocks. Like some sort of stock market spouse, GE is the only company that has stuck through it in the good times and bad. The addition of Apple to the Dow is just another one in a long line of entries and exits and we can expect more in the future. While the Dow is not the best indicator for the overall market, its not going anywhere.

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