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.
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: