housecleaning at the Dow Industrials

Standard and Poors, the part of the McGraw Hill empire that controls the Dow Jones averages, announced today that the Dow Industrials would be bouncing out three of its thirty components, effective September 20th.

The companies to be shown the door are :  Alcoa (AA), Bank of America (BAC) and Hewlett-Packard (HPQ).  Their offense?   …stock prices that are too low, and not enough diversification appeal.

They’re being replaced by:  Goldman Sachs (GS), Visa (V) and Nike (NKE), all of which have higher stock prices and supposedly give the Dow more diversification.

We all know the Dow is a weird index.  That’s because it’s calculated using each stock’s per share price (not the total value of the company’s equity) as the weighting factor.  So a stock that sells for $50 a share has twice the potential impact on the index of a stock that sells for $25–even though the latter may be a much bigger company, with a much larger total market value.

No wonder Alcoa, an $8 stock, and Bank of America ($14.60) are gone.  They’re insignificant!

No surprise, either that Apple ($494) and Google ($888) aren’t in.     …too large.

Why calculate an index this way?  The only answer I can come up with is that in the (computer- and calculator-less) late nineteenth century, when the Dow was invented, the math was simple enough for reporters to get done quickly at the end of the day.

Why does it still exist?   …and why do individual investors still pay attention?  At first blush, the answer is that the Dow is almost all the news media talk about.  But the media would ditch it in a second if the Dow weren’t a surprisingly good mimic of the more sensibly constructed S&P 500, which is what investment professionals use as their benchmark.

Think about it for a minute (something I haven’t done until recently).  What are the chances that a small, wacky index can track the S&P 500 so closely?

As I recall, it wasn’t always this way.  Back in the day, investors tracked the Dow vs. the S&P.  If the Dow was doing better, it meant the ghost of Christmas past was in the room.  If the S&P was outperforming, then smaller stocks in less mature industries were on the relative rise.

Not so much anymore.

It seems to me a tremendous amount of brainpower and computer time has recently gone into–and continues to go into–tuning the Dow Industrials so that they’ll keep on tracking the S&P pretty faithfully.  That’s the really interesting thing about the Dow, to my mind.  And it’s the reason AA, BAC and HPQ had to go–not for diversification, but because they weren’t helping the Dow track the S&P.