Why the Dow Is a Lousy Index to Follow

Source: Thinkstock

Source: Thinkstock

If you look at the three major indexes — the Dow Jones Industrial Average, the S&P 500, and the Nasdaq Composite — you’ll notice that the Dow is underperforming for the year. That might seem a bit strange considering that investors have typically been flocking to large cap stocks that pay higher dividends, and since the Dow has the highest average market capitalization of the three indexes, as well as the highest dividend yield, it would follow that the Dow should be the best performer of the year.

The issue is with how the Dow is composed. Normally indexes rank stocks by market capitalization — the higher the market values a company the more it impacts the value of the index. So for example the S&P 500 will be impacted more by movements in Apple (NASDAQ:AAPL) and Exxon Mobil (NYSE:XOM) than by components with smaller market caps such as John Deere (NYSE:DE) or Yum! Brands (NYSE:YUM).

But the Dow ranks stocks in order of their share price. So even though Exxon Mobil has the highest market capitalization in the Dow the highest weighted stock is actually Visa (NYSE:V) because it has the highest share price. Ironically Chevron has more of an impact on the Dow even though they are in the same industry and even though Exxon Mobil is nearly twice as big because Chevron has a share price of $125 and Exxon has a share price of $101.

As a result the Dow is heavily weighted towards higher priced stocks, and three in particular: Visa, International Business Machines (NYSE:IBM), and Goldman Sachs (NYSE:GS). These three companies make up about 21 percent of the Dow’s movements, and so far this year they have been underperformers.

  • Visa is down 4 percent
  • IBM is down 2 percent
  • Goldman Sachs is down 9 percent

As a result, these three stocks have dragged the Dow down about 160 points this year. Furthermore I don’t think they are done dragging the Dow lower, and therefore I think there is a strong likelihood that the Dow will continue to underperform.

Visa is a great company, and I own shares in it that I bought at about $150. I think it is a very compelling long term investment given its stable growth, secular tailwinds from the fact that consumers are using less cash and more credit and debit cards, and its impeccable business model that generates strong profit margins. But I think the market is going to begin to sell off shares of growth stocks again and so I am not yet adding to my position.

IBM has been slowly rolling over fundamentally for several years now. The company has seen consistent declines in its revenues, and while it managed to keep up its profit growth for some time it failed to do so in Q1. For a while now the company has been keeping up appearances by aggressively buying back stock, but the fact remains that the business is shrinking and margins are compressing. Consequently, I think that this stock is going to continue to decline despite the fact that it trades at just 12 times earnings.

Goldman Sachs is also having problems. Trading volumes are way down because the new Dodd Frank legislation has made the business less appealing. Since this was one of the company’s primary sources of revenue and income, I suspect that the company is going to shrink. Investors should also be concerned about several other factors impacting Goldman Sachs such as continual negative press, executive over-compensation, and too much leverage and exposure to derivatives. Thus while the company trades at just 10 times earnings and below its stated book value, I think it is going to continue to fall and drag the Dow lower with it.

Ultimately the Dow is a lousy index to follow, despite the fact that it makes headlines. Investors should be more focused on larger indexes that give a broader overview of market activity. Good large-cap indexes to follow include the S&P 500, or better yet, the broader yet less popular Russell 1,000. Investors should also follow the Wilshire 5,000 index, which provides a very broad overview of the market—both large cap stocks and small cap stocks. A simple way to follow these indexes is through ETFs, so for these three indexes look at the SPDR S&P 500 ETF (SPY), and the iShares Russell 1,000 Index ETF (IWB). There is no ETF for the Wilshire 5,000 index, but you can easily track it through Yahoo Finance.

Disclosure: Ben Kramer-Miller is long Visa, Exxon Mobil, and Chevron.

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