On Monday, September 23, something we hear about at least five days a week will be moving through a rather rare and very significant change. By that date, the Dow Jones Industrial Average will officially have dropped three components [Alcoa (AA), Bank of America (BAC), and Hewlett-Packard Company (HPQ)] and added three new members [Goldman Sachs (GS), Nike (NKE), and Visa (V)].
MarketTamer thought it would be interesting to use this event as an opportunity to offer you an enjoyable (challenging) quiz and a bit of Dow Jones “history”.
First, here is the “quiz”. Each of the following questions offers a description of a company that has been one of the Dow Jones Industrials. The description intentionally focuses upon the origin of each company.
Your challenge is to guess which Dow stock fits the given description:
1) This company’s history began within the “Pittsburgh Reduction Company”?
2) This19th century chemical company (founded by Balthazar Melick in 1823) is a primary antecedent to a company that currently boasts a market cap of approximately $200 billion. It originally produced nitric acid, camphor, paints, dyes, and medicines.
3) This company (in the Midwest) combined some Irish magic with skilled candle making to create the beginnings of a Dow stock. Sales reached $1 million by 1859!
4) Early in the 20th Century, this company was started as a way to assist the massively under-served immigrants of its era. Within two years, an earthquake proved to be the catalyst for this company’s accelerated expansion.
5) The current business focus of this company was actually forced upon it by a U.S. regulatory and legal decision from 1934.
6) This company was originally an abject failure when started in 1902, but its five partners refused to give up. They switched their business focus to sandpaper products.
7) This company has its roots in oil drilled near San Francisco, as well as in Texas. In the later 20th Century, it was created by the (then) largest merger ever
8) This company has roots going all the way back to 1668! During World War I, this company was confiscated by the U.S. government. Today it is a global business.
9) This company started in a California one-car garage by two grads from Stanford University. Its first customer was Walt Disney, who purchased an audio oscillator.
10) This company proved that (sometimes) capitalism is more powerful than government regulators. In 1911, the U.S. Supreme Court ordered a company disbanded into multiple parts. Eighty-seven years and many corporate restructurings and mergers later, the (by far) largest components from that split-up were re-united into this company.
11) This company was created by someone who formerly worked for J.C. Penney (JCP) and decided to purchase a number of “Ben Franklin Stores” from a mail order company.
12) This company’s first product was santonin, an anti-parasitic used to expel worms from humans.
13) The first product of this company’s antecedent resembled a contemporary French wine. A later reformulation was marketed as a “patent medicine” (to treat dyspepsia, headache, and ED). The company’s true “birth” began through the vision of a man named “Asa”.
14) This company has its roots in one person, and is the biggest of the 14 companies founded by that individual.
15) The first franchise location of this company opened on April 15, 1955, within 9 miles of where I grew up in the Chicago area.
Watch the MarketTamer blog for Part II of this article, which will provide you with the answers to the quiz above… and some more history!
Let’s turn our attention back to the news story that prompted this quiz. The big change within the Dow Jones Industrials Index components (taking effect on September 23rd) is newsworthy for a number of reasons, including at least the following:
1) This long-lived stock index has only been modified fifty-two times since its inauguration on May 26, 1896;
2) It provides a timely moment to remind folks about some market history:
a. Charles Dow, Edward Jones, and (the long ago forgotten) Charles Bergstresser started “Dow Jones & Co.” in 1882.
b. Focusing on investor needs, Charles Dow began tinkering with possible formulations for useful market-related metrics.
c. The first metric (July 3, 1884) was composed of transportation and communication companies (which were among the biggest players in the U.S. economy at the time);
d. The first listing of “Industrial Companies” came in May 1896;
i. It initially including just 12 stocks;
ii. The only one of the “original” Dow companies still in the index is the General Electric Company (GE).
3) This is a great time to highlight (briefly) the difference between the Dow 30’s “price-weighted” index and the S&P 500 Index, which is “market-cap weighted”.
a. Charles Dow originally just added up the prices of the component stocks and divided by the number of stocks in the index (12).
i. In that day, this calculation was simple, straightforward, and it worked!
ii. However, it was not created with an eye toward stock splits or stock dividends. Such corporate actions would significantly skew the “Index” and render it misleading.
iii. Therefore an elaborate process was developed through which a “Dow Jones 30 Divisor” is calculated as needed in order to adjust for such stock events.
b. The S&P 500 Index calculation is weighted by the size of its components’ market caps.
i. Here is a theoretical example: assume XOM has a market cap of $367.5 billion, which when divided by the aggregate market cap of all components within the Index, equals 3.45%;
ii. That means that XOM holds a market cap “weight” within the Index of 3.45%;
iii. If during one market day, XOM goes up by 20% while all other 499 stocks within the Index remain “flat”, the S&P Index would reflect an increase on that day of 0.6899% (20% times XOM’s market weight). 
c. Anyone interested in trading the Dow Jones Industrials Index through an ETF can consider SPDR Dow Jones Industrial Average (DIA). That ETF does not offer anywhere near the daily liquidity provided through the SPDR S&P 500 (SPY), but it is very tradable.
Most experts (and mathematicians) consider the S&P 500 Index to have a “sounder” indexology. However, the long history of the Dow Jones Industrials Index, as well as the familiarity and loyalty it has developed over the decades, does ensure continued use into the distant future.
The most glaring shortcoming of the Dow Jones Index is that (by its nature) component stocks with a higher price exert a disproportionate impact on the calculation of each day’s “gain” or “loss” within the index. This means that, currently, each market day’s index calculation can be somewhat overwhelmed by what IBM does (at about $190/share) versus what AA does (at about $8/share).
In fact, that exact dynamic is at the heart of this current change. IBM (the highest priced component within the DJIA) has the highest weight in the index at about 9.5%. In sharp contrast, the three stocks being dropped, when combined, have only had a weight of around 2.2%!! All three of the stocks being dropped from the Dow have struggled for some time – AA hovers around $8, and although BAC is now over $10 ($14.49) and HPQ is over $20 ($22) – the former struggled for quite some time to get over $9, while HPQ spent a lot of time (prior to March, 2013) below $20.
The impact of this imbedded index weakness will be significantly reduced when V ($189), GS ($164), and NKE ($67.91) join the index. Those higher priced stocks will reduce the overweight of IBM to about 7.97% — and the price of both V and GS (as you can see) fall within the approximate range of IBM.
What might the existential market impact of these changes be with regard to the volatility of the D.J. Index? Alas, that is yet to be determined. For example, reducing IBM’s impact should settle index volatility down a bit. However, it simultaneously increases the number of potential “big name” movers on any given day!
Not to introduce a morbid note here, but this impending major index change introduces the possibility (if not the prospect) of a future change that could be hard to swallow. General Electric Company (GE) presents a fascinating paradox with regard to the “indexology” that I have outlined above. Obviously, it is one of the world’s biggest companies, as well as one of the oldest; and very significantly, it is the only one of the original 12 “Dow” stocks still remaining within the Index! However, its stock price (today) is relatively small!! (It currently isn’t even at $24/share.) If GE hits a rough patch (and moves back under $20/share), there may be some movement to make another adjustment to the Index in the future. GE currently holds only a small 1% weighting within the Dow, coming in almost “dead last” on that metric.
One final note is worth mentioning. There was some historic “Dow Jones Industrials” shifting during the period of the financial crisis. Because AIG (AIG), General Motors (GM), and Citigroup, Inc. (C) relied so heavily on U.S. government largesse during the crisis – each of these stocks was removed from the Dow Index!
Don’t forget to watch for Part II – which will be your “full” Investor Takeaway from this article. You will learn some fascinating history about the corporate legacy we have received, as well as some incredible vignettes of human vision, leadership, and enterprise!
DISCLOSURE: Nothing in this article is intended as a recommendation to buy or sell anything. The author has owned DIA and SPY in the past, as well as various stocks within the Dow Jones Industrial Index. However, he currently owns none of them. Always consult with your financial advisor regarding changes in your portfolio – either subtractions or additions.
 The initial Dow Jones Industrials Index “price” was $40.94. Store that up as a future trivia question.
 It would be hard for many in 2013 to recognize component companies from that era. The first one listed was “Chicago & Northwestern”, which was a Chicago-based railroad that no longer exists.
 See http://www.investopedia.com/terms/d/dowdivisor.asp for more information.
 For more details, see http://www.investopedia.com/ask/answers/05/sp500calculation.asp
 Average volume of 5 million (DIA) versus 73 million (SPY)
 AA, BAC, and HPQ.
 This leaves us in “your guess is as good as mine” territory.
 I think that would be a historical travesty. But no one will ask me, I’m sure.
 I don’t have a time efficient way of ensuring the following is correct, but it is extremely likely that AIG holds the record for the shortest time period being included in the Dow. It was added durin 2004 and removed in 2008!
Also on Market Tamer…
Follow Us on Facebook