The Dow Needs Some Radical Changes

With the stage set for substitutions in the Dow Jones Industrial Average, market observers weigh in with their wish lists for a makeover.
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Alcoa

(AA) - Get Report

,

General Motors

(GM) - Get Report

,

Bank of America

(BAC) - Get Report

and

Citigroup

(C) - Get Report

. All are components of the

Dow Jones Industrial Average

, all are trading in the single digits, and all are prime candidates to be purged from the index in a potential makeover.

As

Jim Cramer pointed out

earlier this week, the prospect of

GM filing for bankruptcy

, coupled with the fact that companies trading in the single digits are frowned upon by the keepers of the Dow, could very well mean its housekeeping time.

"GM probably should go, just as much as some of the banks should go," said Paul Nolte, director of investments with Hinsdale Associates. "My criteria would be that the company hits as broad of an array as possible. You don't want a GM. They affect a lot, absolutely, but they don't participate in a lot."

A major criticism of the Dow is that the index is not as good of a representation of the health of the market as the

S&P 500

. With only 30 components, the Dow certainly doesn't cover as much ground.

One remedy would be to ensure that the Dow has the same sector breakdown for its 30 components as the one on the S&P 500. Currently, the largest sector on the S&P is information technology at 15%, followed closely by health care, energy, financials, and consumer staples, each in the 12% to 15% range. Industrials account for 11% of the S&P 500, followed by consumer discretionary stocks at 8%. Utilities, telecom services and materials each account for only 2% to 4% of the index.

For the Dow, that could mean about four stocks each for the info tech, health care, energy, financials, and consumer staples sectors. Industrials and consumer discretionary sectors would be represented by three stocks each, followed by utilities with two and telecom services and materials by one each.

"I don't know if it necessarily has to be a complete representation or 1-to-1 comparison of the S&P 500," argued Robert Pavlik, chief market strategist with Banyan Partners. "The S&P 500 is a big-picture view of the overall business climate for the country. I don't like the fact that they change the Dow just to get exposure to the hot sectors. The Dow is supposed to be industrials. Does the financial sector really count as industrial?"

Another complaint about the Dow's accuracy in representing overall market performance is that the index is price weighted as opposed to the S&P 500, which is float weighted. This allows for moves in higher-priced stocks like

IBM

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to influence the performance of the Dow more than a stock like

AT&T

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, whose shares trade well below IBM's.

However, the Dow doesn't alter its list of constituents as frequently as the S&P 500. While the Dow has swapped components only six times in the last five years, the S&P 500 implemented 45 index changes in the last year. That doesn't bode well for those expecting dramatic, sweeping changes the next time the editors at

The Wall Street Journal

decide to change the component list of the Dow.

But just for fun, why stop at only four stocks when there are some other potentially smart replacements to be made in addition to GM, Alcoa, Bank of America and Citigroup?

In addition to those four, Pavlik would recommend removing

American Express

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,

3M

(MMM) - Get Report

,

Verizon

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and

Home Depot

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.

Pavlik's eight recommended additions include

Visa

(V) - Get Report

,

Apple

(AAPL) - Get Report

,

Cisco

(CSCO) - Get Report

,

Ingersoll-Rand

(IR) - Get Report

,

Nike

(NKE) - Get Report

,

Emerson Electric

(EMR) - Get Report

, former Dow member

Honeywell

(HON) - Get Report

, and a defense play in the form of either

General Dynamics

(GD) - Get Report

or

Lockheed Martin

(LMT) - Get Report

.

To defend his expulsions, Pavlik reiterates Nolte's point that the stock should have a broad reach to different parts of the U.S. economy. He considers American Express as "still a small player" and says that Visa would be a better choice. AT&T, he says, is a better choice than Verizon because the Dow doesn't need two telecom names.

For his additions to the Dow, Pavlik has a good reason for each one. Apple is a big tech name, but it's "really about the consumer." Nike is a very good read on the retail and consumer discretionary sector, he says. Cisco has a broad business that is recognizable, and it's "a core holding that investors look towards as being one of the big tech names to own first.

"You'd also have to consider putting something back in that's been taken out, like Honeywell," Pavlik added. "It is a very diversified company with broad reaches to different aspects of the economy. I like to think of those types of names."

Nolte has some slightly different ideas. While he agrees with Pavlik that an Emerson Electric or a defense company like General Dynamics makes sense for the Dow because they're "pretty diversified companies and that's what you're looking for if you want the representation of an industrial," he has some interesting choices for deletions.

The choice of

General Electric

(GE) - Get Report

may surprise investors, but Nolte says the company isn't a true representation of industrial companies and would be a good candidate to boot from the index.

"It is more financial than industrial. You could certainly argue that GE is more closely correlated to financials over the last 10 years than it is to the industrials," Nolte said. "GE touches a lot, but unfortunately they're predominately a finance company. Their business line has shifted over the last few years to be that way."

"GE, like it or hate it, is very much a core holding of managed accounts, and I don't think their dominance will ever go away," Pavlik argues. "It goes back to the argument that it is still a core holding."

Looking at the basic materials sector, Nolte isn't sure that

DuPont

(DD) - Get Report

is the best representative to be featured in the Dow. Unfortunately, he says, a lot of the basic materials have a fairly small market cap.

"You still want a basic material, but that's such a small industry anyway," he said. "It's hard to say who the industry leader is. Is it DuPont, or is it a specialty company like

Monsanto

(MON)

? You could even argue to put

U.S. Steel

(X) - Get Report

back in, or you could even pick

Nucor

(NUE) - Get Report

."

Nolte also says he's more apt to include companies that are considered the backbone of technology, like Cisco,

Qualcomm

(QCOM) - Get Report

, or even

Texas Instruments

(TXN) - Get Report

.

Microsoft

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and

Intel

(INTC) - Get Report

are both solid tech plays, but Nolte says an argument can made that both stocks were added to the Dow at their peak. Since being installed on Nov. 1, 1999, Microsoft and Intel have each dropped more than 60% after being adjusted.

Both Pavlik and Nolte argue that while

Google

(GOOG) - Get Report

is considered a monster stock in the tech sector, it's simply not diversified enough for inclusion on the Dow.

Of course, while both market observers agree that such sweeping changes are interesting and should be considered by the Dow's maintainers, Pavlik and Nolte understand the difficulty it takes to properly design the index, given its limitations.

"It's hard to separate performance from representation," said Pavlik. "That's the trouble I have and I think that's probably some of the trouble that the folks that oversee this list have. Having the proper representation of U.S. businesses is very tough."