The Dow Needs to Clean House

"How did the Dow do today?" my wife asked over dinner last week.

I'll be honest. She has never been a major consumer of financial news. However, now that more and more people are swept up in the recessionary gloom, tracking the market's performance via the tragically flawed Dow index of 30 industrial stocks has become as trendy as a pair of Crocs resin shoes circa 2007.

With just about as many holes, too.

Keeping up with the Dow Joneses
I told my wife the truth.

"I don't know," I said. "Can you pass the potatoes?"

I didn't know. Why should I? I haven't followed the Dow Jones Industrial Average in years. I told her how the S&P 500 and the Nasdaq fared -- indices that actually have a material impact on my universe of stocks -- but I'm not going to begin tracking the "Dow" just because of its monosyllabic simplicity.

The index, quite frankly, is a joke.

It's not just that the DJIA is limited to just 30, mostly crusty, stocks. The biggest flaw in the iconic gauge is that it is a price-weighted average. We've been knocking the Dow around here because of that inherent shortcoming for years and years. It's not like the S&P 500, which is more relevant because it's weighted based on market cap. And, come to think of it, even the S&P 500 isn't Little Miss Perfect. It should be leaning on enterprise value instead of market capitalization, but I digress. At least the S&P 500 is somewhat relevant and indicative of the market's actual pulse.

Why are they even here?
In a blog post last week, John Mauldin revisited the theme of the Dow's fatal flaw. Since every dollar shed by a stock in the index results in a nearly eight-point hit on the index itself right now, lower-priced stocks are mostly just taking up space.

There are four Dow stocks trading in the single digits these days, based on last night's close.

  • Citigroup (NYSE: C  ) : $3.45
  • Bank of America (NYSE: BAC  ) : $6.50
  • General Motors (NYSE: GM  ) : $3.35
  • Alcoa (NYSE: AA  ) : $8.61

Do you think they even matter? Doesn't the Dow typically boot these low-priced equities out of there?

Just check out what's going on today. Bank stocks are rallying as I type this, shortly after noon. Citigroup and Bank of America are up 18% and 16% respectively. This would normally be a big ground-shaker for a pool of 30 stocks, but let's look at the real impact. Citigroup’s shares moving $0.64 higher and Bank of America with its $1.04 ascent only amount to 13 points on the Dow.

Thirteen measly points -- or less than 0.2% -- on an index hovering around 8,300 is a joke when we're talking about major moves within a 30-stock measuring stick.

Fellow Dow component IBM (NYSE: IBM  ) closed at $91.66 yesterday. All it would take would be a $1.68 slide in the tech bellwether -- or less than 2% -- to wipe out all of the intraday gains at Citigroup and Bank of America.

Think about that, and tell me if you can ever take the Dow seriously after that.

Banking on change
Citigroup and Bank of America aren't the only financial-services providers on the Dow. American Express (NYSE: AXP  ) and JPMorgan (NYSE: JPM  ) are there with sturdier share prices. However, with those two perched at $17.50 and $25.06 yesterday (respectively), IBM is far greater than all four financial titans combined.

It shouldn't be that way, especially since JPMorgan and your pick of any of the three other financials are in the ballpark of IBM's market cap.

What is the Dow waiting for? It can do three things:

  • It can sweep away the low-priced stocks and replace them with equities that will actually move the needle.
  • It can eliminate the low-priced components and just call itself the Dow 26.
  • It can get with the times and adopt a value-weighted metric.

The third move would be ideal, even if a fossilized gauge will never listen to reason.

The next time my wife asks me how the Dow is doing, I'll have a better answer, and it'll still be the truth.

"Not well," I'll say, regardless of price activity. "Not well at all."

Some other related Foolishness:

JPMorgan Chase is a Motley Fool Income Investor selection. American Express is a Motley Fool Inside Value pick. Bank of America is a former Motley Fool Income Investor recommendation. The Fool owns shares of American Express. Try any of our Foolish newsletters today, free for 30 days

Longtime Fool contributor Rick Munarriz has never been asked to join the S&P 500 or the Dow Jones Industrial Average. He does not own any of the companies in this story. He is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.


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