Some Stress Dow's Distortions

By Jeff Horwitz
Sunday, February 8, 2009

Let's start, shall we, with a hypothetical financial apocalypse: Tomorrow afternoon the stock of every publicly traded financial company in America plunges by 90 percent. Nearly a trillion dollars of shareholder equity in banks and insurers is vaporized, though nonfinancial companies somehow emerge unscathed.

The next morning's headline might well be "Dow Declines Modestly, Financial System Explodes."

Something wrong with this picture?

Critics of the Dow say yes. A controversy over the composition of the Dow Jones industrial average is smoldering in the financial-indexing community, with some alleging that excessive conservatism or political pressure is keeping the Dow from staying abreast of changes in the stock market. If the DJIA's detractors are right, the index could be warping Americans' perception of the financial markets.

The people at Dow Jones -- which created the index back in 1896 -- don't agree. "I think that's hogwash," says Dow Jones index editor John Prestbo, the man responsible for deciding which 30 stocks are included in the most widely recognized gauge of the nation's stock market (more from him in a moment).

Because the Dow Jones industrial average is a "price-weighted" index, companies with high share prices carry proportionally more weight than those with low ones. Instead of IBM accounting for one-30th of the Dow's overall price, these days it accounts for more than 9 percent because of its shares' relatively high price of $96.14. Normally, this isn't a big deal; since the index tracks the performance of leading companies in American economic life, its 30 component stocks tend to have stable, mid-double-digit share prices.

But over the last year, some of the companies in the DJIA have settled to the bottom of the blue-chip barrel. Four now trade for less than $10 a share -- Alcoa ($8.40), Bank of America ($6.13), Citi ($3.91), and General Motors ($2.84). With the exception of J.P. Morgan Chase ($27.63), the index's remaining financials -- American Express and, if you really want to be inclusive, General Electric -- both trade for under $20 apiece. As James Bianco of Bianco Research observed last month, all seven of the companies in this paragraph combined carry less weight in the index than IBM does alone.

In practice, this has reduced the Dow's financial and automotive companies to statistical lightweights. While the two industries are massively important to the American economy and the stock market's overall performance, the Dow affords the sectors far less clout than they carry in "market-weighted" indexes like the S&P 500. To use an extreme example, GM and Citi now trade at a combined $6.79. If both were to drop to zero, the Dow Jones Industrial Average would drop by less than 50 points.

Traditionally, the DJIA hasn't brooked the presence of also-ran stocks. Last September, after the government stepped in to bail out AIG, the Dow promptly dumped the cratered insurer for Kraft Foods. In historic periods of carnage, turnover can be high -- Prestbo's predecessors made more than 20 "substitutions" during the Great Depression.

To keep pace, Bianco argues that Dow Jones again needs to start culling the herd, replacing moribund, government-dependent companies like Citi with healthier financials like Travelers ($39.72) that have the capacity to swing the index.

But here's the rub; doing that would almost certainly harm the prices of the companies that were swapped out. Rightly or wrongly, inclusion in the Dow is a matter of prestige. When AT&T and Kodak lost their places in the Dow in 2004, the change was widely viewed as a blow to their status. (Adding insult to injury, AT&T was replaced in the index by its progeny, Verizon.) Dropping companies like GM and Citi would be politically unpopular, Bianco believes, but it's necessary to reflect how chaotic the market remains.

"I've heard people on CNBC saying that volatility is subsiding, that the Dow's not having three- or four-hundred-point daily swings anymore," Bianco says. "Well, we're now getting the equivalent of those in the S&P, it's just that the Dow's got financials that are preventing it."

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