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The Dow Jones Industrial Average is finally cleaning house. It's dumping a pair of troubled stocks from its 30-stock index, with the now-bankrupt General Motors (NYSE: GM  ) and the capital-challenged Citigroup (NYSE: C  ) being shown the door.

Naturally, the Dow 30 won't become the Dow 28. The two vacancies will be filled by networking giant Cisco (Nasdaq: CSCO  ) and insurer Travelers Group (NYSE: TRV  ) .  

It's about time, really.

The Dow 30 is a popular market gauge for the media, but it's flawed and irrelevant for most investors. Unlike the broader S&P 500, which is weighted based on market cap, the Dow is a price-based index. In other words, IBM (NYSE: IBM  ) at $106.28 is nearly 10 times as influential as Bank of America (NYSE: BAC  ) at $11.27 -- even though Bank of America commands half of IBM's market cap and a higher enterprise value.

For now -- before being readjusted to account for the addition of Cisco and Travelers -- the Dow moves 7.96 points for every point that a stock in its index gains or loses. In other words, even if GM and Citigroup had gone to zero, the Dow would have suffered just a 35-point hit, or a decline of roughly 0.4%. But if the Dow isn't going to be transformed into a market-weighted index, its lower-priced components will never move the needle. This flaw became painfully obvious when six of the Dow's components -- a full 20% of them -- were trading in the single digits three months ago.

Today's move clear out the Dow's two biggest laggards. Following the switch, Alcoa (NYSE: AA  ) will be the only component in the single digits, and the aluminum titan is a good trading day or two away from digging itself out. Three months of market rallies have also helped the index start looking up.

This doesn't mean I'm necessarily applauding the switch. In fact, the Dow's flaws are even more apparent when you consider its two new tenants. Cisco is a much larger company than Travelers, with far more shares outstanding and a much larger market cap. However, because Travelers' share price is more than double what Cisco is commanding, it will be twice as influential in moving the index.

So, kudos for cleaning house, Dow Jones. Now, how about cleaning up the weighting formula, too? It would be nice for you to be relevant again.

Some other ways to get down with the Dow:

Longtime Fool contributor Rick Munarriz has never been asked to join the S&P 500 or the Dow Jones Industrial Average. He owns none of the companies in this story and 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.

Read/Post Comments (5) | Recommend This Article (4)

Comments from our Foolish Readers

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  • Report this Comment On June 01, 2009, at 3:46 PM, tgauchat wrote:

    If ^DJI is not relevant, then how do you explain why it is so highly correlated to other indexes, for example S&P 500 (^GSPC)?

    Poor weightings or not ... the DOW ... IS highly relevant.;ra...

  • Report this Comment On June 01, 2009, at 4:33 PM, redguard314 wrote:

    Remember the lesson from statistics: Correlations don't always imply causation.

  • Report this Comment On June 01, 2009, at 4:53 PM, frappe7601 wrote:

    Remember the converse lesson from the real world. Correlations don't mean causation, but correlation beyond a certain amount just means that you don't understand the causality.

  • Report this Comment On June 01, 2009, at 6:23 PM, TMFBreakerRick wrote:

    tgauchat, fair point, BUT look at how correlated the returns are once several Dow components fell into the single digits.

    Compare the two metrics over the past six months:

    They wind up being roughly 8% apart by the end. Which barometer would you trust?

  • Report this Comment On June 02, 2009, at 12:58 AM, tgauchat wrote:

    Thanks for acknowledgment, and a great question!

    My answer: I think the DOW is relevant, but I most certainly do not TRUST it.

    Since it is easily manipulated by the coordinated efforts of only a few market makers (i.e., the MMs of the heavily price weighted stocks), the DOW is an _ideal_ tool for manipulation of market sentiment.

    Perhaps, just perhaps, this sentiment manipulation via the DOW can _cause_ overall market movement, hence the periodic high correlations.

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