Is The Dow Jones Industrial Average Index Misleading Or Meaningless Or Both?

02/16/2017 08:07 pm ET | Updated Feb 17, 2017
Brendan McDermid / Reuters

Like many of us, I thought that the Dow Jones industrial Average index (DJIA) is comprising thirty of the most important companies of the United States of America by using their market capitalization. I was completely wrong. There is no correlation between the importance of the companies and the index.

According to Wikipedia, DJIA is criticized for being a price weighted average, which gives higher-priced stocks more influence over the average than their lower-priced counterparts, but takes no account of the relative industry size or market capitalization of the components. For example, a $1 increase in a lower-priced stock can be negated by a $1 decrease in a much higher-priced stock, even though the lower-priced stock experienced a larger percentage change. In addition, a $1 move in the smallest component of the DJIA has the same effect as a $1 move in the largest component of the average.

Journalists have been using the DJIA as THE indicator of the strength of 30 of the largest companies in the United States. Size matters for the selection of the companies. Why does it not matter for the weighting of those companies?

Analyzing the composition might be an eye opener!

God bless Goldman Sachs!

Among the 30 companies composing the DJIA index, Goldman Sachs has the lion share. Yes, tiny Goldman is approaching a record $ 100 billion market capitalization. It had a record price yesterday. But few investors might know that 8.32% of the index is represented by Goldman Sachs. Yes, you read well. Each time an investor buys a dollar of the index one twelfth of that money is invested in Goldman Sachs shares. This is pure bonanza, but might explain some of the market value of Goldman. This is confirmed by the fact that an important portion of the twenty largest shareholders of Goldman Sachs are Exchange Traded Funds or indexed funds.

But it is also totally unfair: it gives a structural advantage to Goldman Sachs vis-à-vis its competitors of Wall Street. The next bank, JP Morgan Chase (#16) is only gratified of a 3.01% share while its market capitalization is $ 327 billion. With three times the market cap, JP Morgan Chase is only weighted as 40% of Goldman Sachs. In total, the four companies representing financial sector only represents 16.83% of the DJIA, contrary to conventional wisdom.

What about General Electric?

I do not want to give a heart attack to my former boss and friend, Jack Welch, and my former GE colleagues. However, General Electric is # 30 out of #30. The least important company of the Dow Jones. The fact that it would have a $ 270 billion market capitalization (2.7x Goldman) is irrelevant. It is gratified with a share of 1.10%. When one dollar goes to the DJIA, 8.3 go to Goldman and 1 to General Electric.

Should #8 McDonald be worth 4.20% ($ 105 billion) when Coca Cola ($ 177 billion) # 26 is worth 1.34%. The bottom ten include Microsoft, Intel and Cisco. Why would United Healthcare be # 5 with 5.46% when Pfizer is # 28 with 1.11%.

Telling the truth

No, the index is not manipulated. It has a methodology that explains those aberrations. The DJIA, by not being based on market capitalization, does not represent the substance of the components from an investor’s viewpoint. . It should therefore not be the bell weather of Wall Street. The media, and particularly the Wall Street Journal, have made the DJIA what it is not: an index representing the values of 30 American corporations.

Time for the SEC to look whether the DJIA might need to be more transparent to investors? Maybe the media should reconsider this index that, in fact, is meaningless.