New Changes To The Dow, Should You Care?

| June 8, 2009 | 0 Comments

Today, two icons of American business are being removed from the Dow Jones Industrial Average.  Thanks for playing, General Motors (GM) and Citigroup (C).  Hello, Travelers (TRV) and Cisco Systems (CSCO).

Once upon a time, GM and Citi were titans of their industries.  They’ve been reduced to wards of the state (or federal government).  GM is now in bankruptcy.  Citi is holding on by a thread, thanks to the ‘too big to fail’ policies and billions of dollars of bailout money.

The recession’s exposed the inept management and over leveraging (too much debt) of these institutions.  In a truly free market, these companies would have been gone long ago.

Now that their day has finally arrived, what does this Dow shake up mean?

Not much really.  The Dow is largely irrelevant as an index.

Let me explain.  It’s impossible to gauge an entire stock market based on 30 stocks.  To make matters worse, the Dow is price weighted, not market cap weighted.  That means companies with the highest stock prices have the biggest impact on the Dow.

However, stock price isn’t everything.  A higher stock price doesn’t mean the company is bigger or better.  Companies’ stock prices will vary due to how many shares they have issued.  A better measure of a company’s impact is its market cap.

Market cap (short for capitalization) measures the size of a company.  It’s easy to calculate.  Simply multiply the number of shares outstanding by the current price.

It stands to reason the larger the company, the bigger the impact on the economy (and any index it’s part of).

For example, let’s look at the two new companies being added to the Dow today.  Travelers’ stock price is $43.75 and Cisco’s is $19.87.  Since Travelers stock price is much higher than Cisco, the Dow’s price weighting model gives more weight to Travelers.

Now let’s look at their market caps.

Travelers has a market cap of $25 billion.  Cisco has a market cap $112 billion.  Cisco is more than 4X bigger than Travelers.  Yet, Travelers will have a bigger impact on the Dow because its price is higher… it’s no wonder the Dow’s no longer relevant.

However, there is still one area the Dow is useful.

That’s as a gauge of public sentiment.  The Dow’s the most well known of any index; it’s really an iconic measure of the markets.  It dates back to 1896.

Among people with little financial knowledge, the Dow is a widely known gauge on the financial markets.  The widespread use of the Dow in the media keeps it relevant.  Not for any practical application but for gauging everyone else’s feelings on the market.

The next time you look to see what the market is doing, look to the S&P 500 and NASDAQ.  They’re much better indicators of what’s transpiring.

You’ll be a smarter investor.

Which brings us back to the removal of the two failed companies.  Even though these companies will continue to operate, the markets are finally able to voice their opinion.  They’re saying, these companies are not viable in a free market.  And I agree whole heartedly.

Companies should be allowed to fail.  It isn’t government’s job to save them from themselves.  At least the government can’t dictate which companies are included in the Dow.  The free market lives on… sort of.

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Category: Stocks

About the Author ()

Corey Williams is the editor of Sector ETF Trader, an investment advisory service focused on profiting from ETFs and the economic cycle. Under Corey’s leadership, the Sector ETF Trader has become one of the most popular and successful ETF advisories around. In addition to his groundbreaking service, Corey is the lead contributor to ETF Trading Research, where he shares his insights about ETFs and financial markets on a daily basis. He’s also a regular contributor to the Dynamic Wealth Report and the editor of one the hottest option trading services around – Elite Option Trader.

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