The Dow Jones: An Index of “Weight,” Not Fundamentals or Value

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For three months we saw constant coverage as the Dow Jones made its trip and its ultimate surpassing of its all-time high. While this created euphoria, and gains within the overall market, many have an incorrect assumption of the index. And in this piece I am here to set the record straight, and teach you how to use the index to your advantage.

A Thesis for Dow Jones Trouble

The Dow Jones is the most noticed index in U.S. markets, and after last week’s losses, there are several economists who are expecting a pullback. The reason is because three of the most heavily weighed companies in the index are experiencing fundamental hardships.

  • International Business Machines (NYSE: IBM) saw losses of 8% on Friday after reporting sloppy earnings, including a revenue decline of 5% year-over-year (yoy). The company’s hardware sales were down a whopping 17%, suggesting future problems and a possible change in sentiment. Furthermore, the company missed on the bottom line, and this occurred despite a significantly lower tax rate. These factors combined suggest future losses for the most heavily weighted stock in the index.
  • Caterpillar (NYSE: CAT) has lost 10% of its value YTD, as slowing growth in China creates fear among investors. In the month of March alone, sales of its construction and mining equipment business fell 11%, mostly due to a 24% decline in the Asia/Pacific region. These fundamental declines have the stock trading near 52-week lows, and many believe there is much room for further declines.
  • McDonald’s (NYSE: MCD) is not weighed as heavily as Caterpillar or IBM, but was trading at all-time highs and is trading at a large premium to the market. This fact, combined with a 2% loss on Friday with disappointing earnings. This weakness was sparked by a 1% drop in U.S. comparable store-sales, and also margin weakness due to higher costs.

When you combine the McDonald’s’ weaknesses with its other large weighted Dow stocks, you have three companies that could cause trouble for the Dow Jones. However, my belief is that the Dow Jones is nothing more than a psychological index of opportunity. When it trades higher, it’s very possible that the overall economy is not performing up to par (but rather just a few heavily weighed companies). Yet when it trades lower, and fear spreads, investors can often locate value. Allow me to explain.

Dow Jones: Its Value is Not What it Seems

While the Dow Jones is the most noticed index in the U.S. market, it is also the smallest of the three major indexes. It is compiled of just 30 “blue chip” stocks that cover all sectors. However, what’s most important is that it’s a price weighted index, meaning stocks with higher stock prices have more weight on its performance/valuation.

For an index to be weighed by price, you are discounting fundamental teachings, one being that a company should be weighed by its market capitalization and its fundamentals. Therefore, the “value” of the Dow Jones is incorrectly priced.

On Friday, International Business Machines posted an 8.28% loss after announcing bad earnings. Meanwhile, General Electric (NYSE: GE) closed with a 4% loss also following earnings. As you know, the Dow Jones closed with gains of 10 points, however these two stocks alone created a loss of 136.76 points on the index.

If you look at General Electric and IBM side-by-side they both command a market presence of over $200 billion. In fact, General Electric has a market cap that is $14 billion larger than IBM. Basically, you could add Alcoa’s market cap of $8.64 billion (another Dow Jones component) to IBM and GE would still be the larger company.

Despite the fact that General Electric is the larger company, it also has more issued shares (10.4 billion) compared to IBM’s (1.12 billion), therefore is priced lower. IBM trades with a price of $190 while GE trades at $21.75. As a result, despite GE being the larger company, it is weighed lighter on the Dow Jones Industrial Average.

On Friday, IBM created a 129.80 point loss on the Dow Jones with its 8% loss. GE created a 6.96 point loss with its 4% loss. No matter how you look at it, these numbers don’t make sense. Then when you incorporate the low weights placed on companies Bank of America, Cisco, and Intel compared to the high weights of others like Caterpillar and McDonald’s you see further that the Dow Jones average is far from being a perfect system of performance in the economy.

Conclusion

“Investors are quick to become overly emotional, creating unnecessary excitement. When this occurs be on the lookout, as this is when value is created.” -- Taking Charge With Value Investing (McGraw-Hill, 2013)

Above is a quote from my new book, and it means that opportunistic investors should use the things that are overemphasized in the market to their advantage. One being the Dow Jones, as its performance is not at all an indication of true economic growth/performance. “If” the index trades lower in the upcoming months, it may not necessarily mean that the economy is regressing, but rather heavily weighted stocks are seeing weakness. At that point, seek value, and search for companies that have traded lower despite strong fundamental performance. Then, you will be rewarded with strong gains.


Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends McDonald's. The Motley Fool owns shares of General Electric Company, International Business Machines., and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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