In the stock market, not all numbers are created equal. Photo by Courtney Keating/Getty Images.
Tuesday evening, Convergex Trading’s Nicholas Colas and Jessica Rabe released an interesting note that caught our eye, highlighting a curiosity in the Dow’s 1.8% return thus far in 2015 (on a price basis). Colas and Rabe point out the year’s modest positive return is accounted for by only two stocks: Goldman Sachs and United Healthcare. That’s it! The other 28 stocks’ returns net to basically zero. They go on to discuss the fact the top 10 Dow stocks dominate the gauge’s return, suggesting whatever big round number you think is next for the Dow, your outlook better hinge on the top 10 stocks. While they don’t come right out and say it, this echoes a point we’ve long made here: Narrow, price-weighted gauges like the Dow are fatally flawed. The Dow simply does not reflect the US stock market, and investors would be well served to set it aside in favor of broader, market-cap weighted indexes.
Price-weighted indexes assign more importance to stocks with higher per-share prices. As of May 31, the highest-priced Dow stock is Goldman Sachs, at $206 per share.[i] But the Dow’s movement isn’t in dollars, it is in points. And to translate that $206 share price to points, S&P Dow Jones uses a divisor—presently 0.14985889030177.[ii] This divisor is then applied to all the Dow members’ share prices, so you can pretty simply determine the number of points ascribed to each of the Dow’s 30 components. (Exhibit 1)
Exhibit 1: DOW Constituents by Points
Source: S&P Dow Jones, Factset. All share prices are as of 5/31/2015.
Price weighting’s primary flaw is it doesn’t factor in the relative sizes of the firms included. The S&P 500 or MSCI World, by contrast, are market-capitalization weighted, which better accounts for a firm’s value in the marketplace. With a 1,376 point weight, Goldman Sachs means about as much to the Dow’s daily movement as General Electric, Cisco, Intel, Pfizer, Coca-Cola and Microsoft combined. Yet Goldman’s market cap is only $83.5 billion—big, but a fraction of the combined $1.35 trillion market cap of the bottom six Dow stocks. Heck, Goldman easily tops Apple’s Dow point contribution despite Apple having a market cap nine times bigger. Travelers’ Insurance is #12 of the Dow 30 by weight. Yet this firm has a market capitalization of $31.9 billion—which ranks it 145th in the S&P 500. Microsoft is the US’s second largest firm, with a market cap of $384.4 billion, or more than 10 times larger than Travelers. Yet the Dow places over twice as much importance on Travelers because its $101.82 share price is more than double Microsoft’s $46.86.
Expanding this to the top four further shows how price weighting skews the Dow from reality. Goldman, IBM, 3M and Boeing total 4,507 Dow points—only about 1% less than the bottom 13 firms’ 4,551. Yet those top four point contributors total $432 billion in market cap, around 17% of the bottom 13’s roughly $2.5 trillion.
So given this top-heavy, price-weighted nature, does the Dow actually capture the movement of 30 well-known US stocks? In our view, no. Consider: Based on price weighting and the divisor, General Electric rising 50% this year would add a measly 91 points to the Dow—that’s 0.5% if you’re scoring at home. If Goldman falls -6% over the same span, GE’s contribution will be entirely offset. Heck, in the unlikely circumstance the top 19 Dow stocks netted to flat while GE, Cisco, Intel, Pfizer, Coca-Cola, Microsoft, Verizon, Merck, JPMorgan, Visa and DuPont all went to zero, the Dow wouldn’t be in technical bear market territory (-20%), because those 11 firms don’t total 20% of the Dow’s point value. Since 11 stocks in the gauge can technically evaporate without impacting the market cycle, it doesn’t seem the Dow really captures the movement of 30 stocks at all.
While it is equally true that the S&P 500’s smallest members also contribute comparatively little to returns, that’s at least tied to the fact they have a smaller overall value rather than merely a lower share price. And, those are members in a much broader gauge of 500 stocks covering all 10 sectors. The Dow is 30 stocks in 8 sectors. Narrow and price-weighted is no way to gauge the broad stock market.
[i] FactSet, as of 6/24/2015.