Apple recently retook the throne as the world’s most valuable company, stripping the title from energy giant ExxonMobil. For the folks on our customer support desk, this means one thing: They can expect a few questions over the coming weeks about whether Apple might be added to the Dow Jones Industrial Average. (And the next question is usually: What about Google?)
To understand why these companies aren’t currently included in the index, let’s first take a step back and consider The Dow’s mission: To reliably measure the performance of the U.S. stock market.
This is a mission that The Dow fulfills quite well. In fact, its correlation with the Dow Jones Total Stock Market Index (which contains all publicly traded U.S. securities) is 97.4%*. That it achieves this goal through just 30 stocks is somewhat remarkable. The basket must, in effect, serve as a microcosm of the U.S. market. To this end, care is taken, for example, in reviewing its sector make-up. And when one stock is replaced, the entire index composition is reviewed to make sure that in aggregate, the stocks form a representative sample of the market.
Typically a company is added to The Dow only if has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors. While it’s true that both Apple and Google would certainly seem to meet these criteria, this qualification doesn’t necessitate their inclusion in The Dow—nor does their sheer size, although it also weighs in their favor. The Dow’s methodology allows for subjectivity, and ultimately stock changes are made at the discretion of the Averages Committee.
With that as background, the question remains: Will Apple or Google be added to The Dow anytime soon? The short answer is “no”—at least not at their current share prices. As you probably know, the stock prices of Apple ($477) and Google ($610) are extremely high relative to the average U.S. stock. For comparison, the average price of DJIA component stocks currently stands at $57.
If you’re wondering why this matters, keep in mind that The Dow is “price-weighted.” This means that its movement depends entirely on changes in its component stocks’ prices. In practice, this means that Apple would have more than 10 times the impact on The Dow’s level than would current DJIA component Home Depot, which is trading around $45. In fact, at today’s prices, Apple would represent about 28% of The Dow’s movement on any given day.
Consider Google’s January 20 decline of 8%, after it reported earnings that fell short of the Street’s expectations. If it had been a member of The Dow, the repercussions would have been severe. Instead, The Dow closed the day up 0.76%. Of course, it works both ways: When Apple soared 8% on Jan 24, we would have seen The Dow swing upward. Regardless of the direction, though, the inclusion of these stocks would almost necessarily increase the volatility of The Dow, and more importantly, hamper its ability to accurately reflect the broader market.
Now, there is what some might consider an easy fix to this conundrum: We could change The Dow’s methodology so that it weights stocks not by price, but by market capitalization. Most modern indexes use this method, which accounts for component stocks’ prices multiplied by their outstanding shares.
But to do this we must sacrifice The Dow’s historical continuity. You see, The Dow is unique in that it has been continuously calculated using the same methodology for more than a century. The importance of having this deep market history becomes abundantly clear when you start to analyze long-term market trends. Consider that the average business cycle, according the National Bureau of Economic Research, is 55 months from peak to peak. Many modern indexes have historical data that date back only a decade or so, long enough to capture only two of these cycles. Over The Dow’s 116-year history, there have been 23 business cycles. Wonder how the market will perform as we come out of a recession? Or how it might respond to changes in economic policy? The Dow is the index that offers the most complete dataset. Changing the methodology would essentially obliterate this history.
There will always be those who call The Dow’s methodology old-fashioned, or question its approach. But is the historical continuity easy to give up? The calculation we make is that the pros of keeping The Dow the way it is far outweigh the cons.
*36-month total-return correlation as of 1/31/12