Per our last discussion, we discovered that the Dow is a price-weighted index. Another common way an index is built is capitalization-weighted (i.e. the S&P 500 Index). The impact of a capitalization-weighted index is that as a component’s price changes, it is in proportion to the issue’s overall market value, which is the share price times the number of shares outstanding. However, this is not how the Dow works; rather it is calculated by adding the price of 1 share of each of the 30 component company’s share prices together and dividing it by a divisor (which was discussed last time). Some may argue that a price-weighted index doesn’t make much sense. Let’s dig in.

First, you should know that the keeper of the Dow, Dow Jones, has an unwritten rule that any DJIA stock that falls and stays for an extended period of time below $10 gets tossed out. Currently, there are 4 stocks trading less than $10 (GE is flirting, but I won’t include that…yet).

Alcoa (AA) = $7.06

Bank of America (BAC) = $5.83

Citi (C) = $2.69

General Motors (GM) = $2.59

If all four of these stocks went to zero on today’s open, the Dow would lose only 144 points!

The financials in the Dow are:

Amex (AXP) = $13.71

Bank of America (BAC) = $5.83

Citi (C) = $2.69

JPMorgan (JPM) = $18.09

If every financial stock in the Dow went to zero on today’s open, it would only loose 368 points! This number used to be huge, but nowadays, a 300 point swing is commonplace.

It gets crazier. If all sub-$10 stocks listed above, all the financials listed, AND GE opened at zero (AA, BAC, C, GM, AXP, JPM and GE), the Dow loses 522 points. Now, say just one company, IBM, opens at zero, the Dow loses 706 points! So, the Dow says that IBM has more influence on the index than all the financials, autos, GE, and Alcoa combined. To look at it another way, a 10% positive move for IBM would move the Dow up by over 70 points. A 10% move by Citigroup would increase the Dow by barely over 2 points.

The component companies are decided upon by the Index Committee at Dow Jones. This Committee will remove and replace companies as it sees fit, whether it be the sub-$10 unwritten rule, or if they feel a different company would represent the American economy better than a current component (i.e. in 1999 Microsoft replaced Goodyear Tire & Rubber to make way for the technology revolution). Some argue that the Dow Jones Index Committee isn’t doing their job because they aren’t removing the sub-$10 stocks during this crisis, possibly because of the political fallout of booting out Citi or GM. As a result, this index is now severely distorted as it has tiny weightings to stocks that don’t move the charts much. While these 30 companies could be debated if they represent the American economy well, I’m sure we’d all agree that now that we know how a price-weighted index works, we’ll be a lot wiser when we hear how the Dow did on any particular day.


Disclaimer:    For all you anal ones out there double checking my numbers, I used the intra-day prices of the Dow 30 stocks on the morning of February 26, 2009 and the divisor from my previous post.