How Does Da DOW Do Dat?
I have had numerous queries from students, ardent readers and the like, about how the price dips on thevarious DOW components have affected the DOW and what happens to the Dow Jones Industrial Average when lower capitalized stocks get replaced by higher capped ones? Or how does Citicorp (C) or Bank of America (BAC) qualify to stay in the DOW30 when it is obvious that there other companies that are currently higher capitalized? Or if and when C and/or BAC get swopped for other stocks, what kind of reaction will we see on the DOW or will the DOW react at all?
And my favorite one of all … in the event that ALL the stocks get down to pennies, what will that do to the DOW?
I’m no expert on the DOW but I do know that all these queries are really non-events. In other words, I doubt very much that any of the above queries will see the kind of reactions you’d expect. In other words, it’s rather boring.
First of all, know that an Index is only a statistical measure of change in an economy or a securities market. In the case of financial markets, an index is an imaginary portfolio of securities representing a particular market or a portion of it. Each index has its own calculation methodology and is usually expressed in terms of a change from a base value. Thus, the percentage change is more important than the actual numeric value.
The Dow Jones Averages are unique in that they are price weighted rather than market capitalization weighted. That simply means that their component weightings are affected only by changes in the stocks’ prices, in comparison to other indexes’ weightings that are affected by both price changes and changes in the number of shares outstanding.
The indexes are just what their names imply: basic, easy-to-calculate averages. To calculate one of the averages, simply add up the prices of its components on their primary exchanges and divide the sum by the divisor.
An index divisor is a crucial number in the calculation of the value of an index. This number is used in the denominator of the ratio between the total value of an index and the index divisor. The number, which typically has little mathematical rationale behind it, remains consistent and therefore enables comparability within the index over time. It is the basis for comparability across time, and the starting point for adjustments that need to be made due to changes in the equity composition of the underlying companies in the index.
Some of the adjustments that may need to be made to the divisor include changes in the number of shares floated by a company, any rights offerings made to employees or management, and any share repurchases.
Over the years, adjustments have been made to the divisors to ensure the continuity of the averages after corporate actions such as spin-offs and stock splits. As a result the divisors are no longer equal to the number of components in each of the averages, as would be expected. For example, after 100 years of adjustments, the current divisor for the Dow Jones Industrial Average available here, is less than one.
Below is the formula for calculating a divisor change:
But to explain this in a practical sense, when DOW swopped HON (Honeywell) and MO (Altria) for BAC (Bank of America) and CVX (Chevron) and when MO spun off KFT (Kraft) and KFT replaced AIG, … there was hardly a stir or a ripple. The DOW even remained non-reactionary, unlike the S&P500 that experiences major gyrations whenever there’s an Index Addition.
It could be the price weightage of the DOW’s system that allows for the smooth transition rather that cap weightage which will surely feel like the Texas Cyclone. Whatever the reason, I have never had a reactionary day on the DOW just because of a replacement/addition.
Furthermore, such substitutions are sounded off weeks in advance so the index has time to price-in any compensatory move, if necessary. The advance call nullifies any shocks to the system and the transition, as proven in the past, becomes transparent.
You may want to follow this link which will further help enlighten your understanding of this subject:
Dow Jones Averages 5-10 Methodology Overview
As for the stocks getting down to pennies … although I would hate to see that happen, it would be interesting to actually experience it. One must wonder what it would be like to be a trader in penny ranges. But realistically, I doubt if we’ll ever get to that … but having said that, today’s economy hold little surprises for me anymore.
Dare I say it … “It can never happen.”
If you enjoyed this post, please consider to visit Pattern Trader Tools, leave a comment or subscribe to the feed and get future articles delivered to your feed reader.
Comments
No comments yet.
Sorry, the comment form is closed at this time.