The Dow 30 continues to be presented and endorsed as a true reflection of the health of the economy yet it is anything but. The truth of the matter is that it's deceptive in what it purports to represent. The manipulation of the performance of the Dow 30 has been going on since 1928 and it gets further denigrated on September 23rd with a 3 constituent swap which will, in effect, assure that it continues to rise in the long term. This article outlines the extent of this reconfiguring (and the resultant change in the Dow Divisor) and the extent to which doing so will affect the performance of the index. Read on. The effect is significant.
It is becoming more and more meaningless to compare the Dow 30′s performance from one period of time to another. Why? Because continuing replacement of mature constituent companies with lower priced stocks (i.e. losers out) with companies with higher priced stocks with anticipated greater future growth prospects for price appreciation (i.e. winners in), as is happening again on September 23rd, is nothing short of injecting the index with growth hormones making any performance comparison over the years of its existence invalid.
The Dow 30 Index Is Deceptive
An index is calculated on the basis of a basket of shares and a set formula that is used as the criteria for arriving at the number of points of the index. However, in the case of the Dow 30, the basket of shares change frequently and the formula on which the value of the index is calculated keeps changing.
Over the past 10 years, for example, 40% of the constituents of the Dow 30 have changed and a full 67% have changed over the past 16 years. In effect, whenever the Dow 30 undergoes a change in constituents it makes it impossible to compare its performance from one year to the next on a consistent basis. In spite of that, however, the Dow 30 continues to be presented and endorsed as a true reflection of the health of the economy yet it is anything but. The truth of the matter is that the Dow 30 is deceptive in what it purports to represent.
Generally speaking, the companies that are removed from the list of Dow 30 constituents are in a stabilization or degeneration phase and companies in a take-off or acceleration phase are added. This greatly increases the chance that the index will rise rather than go down. This is obvious, especially when this is done during the acceleration phase of a transition.
The abovementioned phases are exemplified in the deletions and additions of constituents to the Dow 30 next week.
The following 3 mature constituents of the Dow 30 are being removed are:
- Hewlett- Packard Co.
- Bank of America Inc.
- Alcoa Inc.
- the average share price of the stocks of the above companies is approximately $15/share (sum total value of approx. $45)
The 3 replacement companies with anticipated greater future prospects for price appreciation being added are:
- Goldman Sachs Group Inc.
- Nike Inc.
- Visa Inc.
- the average share price of the stocks of the above companies is approximately $145/share (sum total value of $434)
The Dow Divisor
With every change in the set of shares used to calculate the number of points the formula to calculate its "true" value also changes. This is deemed necessary to ensure that the sum total value of the previous basket of constituents matches the value of the new basket of constituents thereby allowing for a continuous smooth progression on the chart for the Dow. This is accomplished by the application of a mathematical calculation called the Dow Divisor.
The Dow Divisor ensures that the value of the Dow with the new shares is the same as the value of the Dow 30 with the old shares but this is effective only in the short term. In the longer term the profits of the higher priced stocks are greater/stronger than those of the weaker stocks that they replaced resulting in a disproportionate positive influence on the performance of the Dow 30 as a whole.
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