Purge GM from the Dow?

Business Week asks if GM (GM) should be replaced in the Dow.
My answer is a resounding: Duh!
And take Alcoa (AA) with you.
First, there’s a little back story involved. The Dow Jones Indexes are owned coincidentally enough by Dow Jones & Co. (DJ). The company also publishes Barron’s and the Wall Street Journal. Business Week is owned by McGraw Hill (MHP) which also owns Standard & Poor’s, which coincidentally enough, owns the S&P Indexes. So we have a little inter-indexian warfare going on.
I’ll be very simple: The Dow is a lousy index. The big advantage it has is age. The Dow is a price-weighted index which means that it’s calculated by adding up the 30 stocks and multiplying by a variable (about eight) to get the magic number.
The S&P 500 is much better and it’s the one I follow most closely. The stocks are weighted by market value and it uses 500 stocks. Over the past few decades, the Dow has slowly lost ground relative to the S&P 500.
Forty years ago, the Dow was about 10 times the S&P. Thirty years ago, it was nine times. Twenty-five years ago, it fell below eight and twenty years ago, it fell below seven. Beginning in the mid-80s, the Dow regained some of its lost ground. The Dow generally falls less than the market as a whole during bear markets, and trails it during bull markets.
The bursting of the tech bubble was good news for the Dow. By the market’s low, the index vaulted all the way to 9.75 times the S&P. Since then, it’s been three-and-a-half rough years for the Dow. The ratio is back down to 8.6.
General Motors now has a market value of roughly $10 billion, about one-twelfth that of Google (GOOG). Its debt, which is rated as junk, represents about 4,000 Dow points. The company is simply no longer a good barometer of the American economy.
Here’s an interesting tidbit on the Dow. The editors of the Wall Street Journal changed the index in 1939 by tossing out IBM (IBM). They added it back in 1979. In those 40 years, IBM gained 22,000% If the editors had left the index alone, the Dow would now be about 35% higher than where it is.
All the historical benchmarks would be different. The Dow would have cracked 1,000 in 1961 instead of twelve years later. Behold the power of one really great stock!

Posted by on January 3rd, 2006 at 2:38 pm


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