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The Dow's Pending Changes Show Why the Dow Should Be Ignored

The market cap-weighted S&P 500 and Russell 2000 provide a much better read on U.S. equity markets than the price-weighted Dow.
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If investors looking to quickly gauge how U.S. equities are performing needed more reasons to ignore the Dow Jones Industrial Average in favor of the S&P 500 and Russell 2000, the Dow’s selection committee provided them on Monday.

On Monday evening, S&P Dow Jones said that  (CRM) - Get Free Report will replace Exxon Mobil  (XOM) - Get Free Report, Amgen  (AMGN) - Get Free Report will replace Pfizer  (PFE) - Get Free Report and Honeywell  (HON) - Get Free Report will replace Raytheon  (RTX) - Get Free Report in the Dow. The changes take effect prior to the start of trading on Monday, Aug. 31.

S&P Dow Jones partly attributed the changes to Dow component Apple’s  (AAPL) - Get Free Report pending 4-for-1 split, which (since the index is stock price-weighted) will reduce the Dow’s tech sector exposure. It also argued the changes will “help diversify the index by removing overlap between companies of similar scope and adding new types of businesses that better reflect the American economy.”

Salesforce, which reports earnings after Tuesday’s close, will become the Dow’s sixth tech sector company, joining Apple, Microsoft  (MSFT) - Get Free Report, Intel  (INTC) - Get Free Report, IBM  (IBM) - Get Free Report and Cisco Systems  (CSCO) - Get Free Report. That in turn means Salesforce was selected over Alphabet  (GOOG) - Get Free Report,  (AMZN) - Get Free Report and Facebook  (FB) - Get Free Report.

Why Salesforce was picked over Alphabet and Amazon isn’t hard to understand: Since the Dow is price-weighted, adding Alphabet, whose shares currently trade around $1,600, or Amazon, whose shares trade above $3,300, would lead either company to account for an enormous percentage of the index’s weighting. Adding Salesforce, whose shares trade around $215, doesn’t cause a similar problem.

But the fact that something as arbitrary as whether a company has split its stock enough to trade below $300 or so can determine whether it deserves to be in an index -- never mind that the company might be one of the most valuable firms on the planet -- drives home just how arbitrary and irrational a price-weighted index’s mechanics can feel.

So does, for that matter, the fact that Apple’s Dow weighting is going to be cut by 75% following its split. This will give Apple a smaller weighting than Dow components such as Boeing  (BA) - Get Free Report and 3M  (MMM) - Get Free Report, whose market caps aren’t one-twentieth as large.

As for why Salesforce was picked over Facebook, whose shares currently trade at $281 and whose market cap is more than four times larger than Salesforce’s, that’s something that only the Dow’s five-member selection committee can definitively answer.

Perhaps the committee felt that it was necessary to have another software company join the index, given how large and strategically important of a role software companies now collectively play within the U.S. economy (online advertising, of course, is also a pretty big deal these days). Or perhaps the negative publicity that Facebook has received in recent years gave it pause.

But regardless of the committee’s thought process, the fact that the Dow can only have 30 companies at any given time will inevitably lead a lot of important and valuable U.S. companies to be left out. Sometimes its reasoning for picking one company over another will look pretty sound; sometimes it will look pretty questionable.

Either way, this is a much smaller problem for the S&P 500, since it has 500 components rather than 30. While there can still be debate about which smaller companies make it in, and while profitability requirements can keep some growth-stage, large-cap, tech companies out for a while, you definitely don’t have to worry about the likes of Alphabet, Amazon and Facebook not making the cut.

And since the S&P is -- like the Nasdaq, the small cap-focused Russell 2000 and most other indexes -- market cap-weighted rather than price-weighted, stock splits (or lack thereof) have no impact on a component’s weighting.

Between them, the S&P and the Russell have long delivered a much better read on what’s going on in U.S. equity markets at a given point in time than the Dow. The Dow’s pending changes serve as a fresh reminder of why that’s the case.