For more than 122 years, the Dow Jones Industrial Average (^DJI 0.08%) has been viewed as America's leading stock market index. Retail investors sitting in front of their computers to seasoned Wall Street veterans rely on the Dow to provide a glimpse of the health of the U.S. economy and the strength of its stock market.
The Dow's plain-as-day flaw
But for all of its nostalgia and the more than 50 component changes the index has undergone since its inception on May 26, 1896, the Dow also comes with a pretty glaring flaw: it's a price-weighted, not market-cap-weighted, index. Or in other words, share price, not market cap, is what matters.
Recently, industrial conglomerate General Electric (GE 2.58%), which had been a fixture in the Dow for the past 110-plus years, was shown the door by the S&P Dow Jones Indices committee that meets a few times annually and is responsible for changing components in the Dow from time to time.
What's notable about this move is that General Electric still maintained a market cap of around $115 billion when it was given the boot by the committee. This meant it was larger than six current Dow components based on market cap, and placed around No. 65 overall in market cap for publicly traded companies in the United States. In short, it wasn't exactly an irrelevant company.
However, General Electric's share price had come under fire for weakening sales in a number of key operating segments. After sinking by more than 60% in a two-year span, GE was left to trade at $13 per share. Based on the Dow divisor published by The Wall Street Journal, General Electric was only responsible for about 90 of the Dow's 25,300-plus points. This made it expendable in the eyes of the S&P Dow Jones Indices committee.
Say hello to the Dow's three most important components
Because of the way the Dow Jones Industrial Average is calculated -- i.e., its emphasis on share price instead of market cap -- the eight largest Dow components by market cap aren't even in the top three in terms of importance. This means that tech giants Apple and Microsoft, which sport respective market caps of $933 billion and $810 billion and have significant weighting in the broader-based S&P 500, aren't the leading movers of the Dow. Instead, the ninth, 14th, and 26th largest market caps in the Dow have the highest weighting, based on share price.
In terms of weighting, no Dow stock has more sway than airplane manufacturer Boeing (BA -0.73%). Despite only being the 14th largest Dow stock by market cap, its $351 share price is unquestionably the largest. Based on the Dow divisor, Boeing is responsible for 2,380 Dow points, or nearly 10% of the index!
Thankfully for the Dow, Boeing's stock has been practically unstoppable over the trailing two-year period, with shares up 167%. As my colleague Daniel Miller pointed out in June, some 41,030 commercial aircraft are expected to be needed over the next two decades, with Boeing in great position to land a significant percentage of these orders. And this doesn't even touch on the company's burgeoning defense business, which continues to flourish thanks to America's leading defense budget.
The largest health insurer in the country UnitedHealth Group (UNH -1.31%) is the second most important stock in the Dow, based on share price. Even though it has only the ninth largest market cap among Dow components, UnitedHealth's $254 share price translates into 1,721 Dow points.
Like Boeing, UnitedHealth Group has been on a tear. Over the trailing five-year period, its share price has risen a cool 248%, which has been a big boost to the Dow. UnitedHealth initially benefited from investor expectations surrounding the rollout of the Affordable Care Act (ACA) in 2014, but has since found improved margins by pulling away from the ACA, focusing on its commercial plan pricing power, and leaning on its fast-growing health services business, Optum.
Lastly, we have to go all the way to the 26th largest Dow component by market cap (remember, there are only 30) to find the third most important stock: investment bank Goldman Sachs (GS -0.36%). Goldman totes around a $90 billion market cap, which is less than a tenth the size of Apple, but its $239 share price commands 1,620 Dow points.
Over the trailing two years, Goldman Sachs' share price has risen by 47% -- albeit it's been a choppy ride at times. Goldman's latest quarterly report highlighted ridiculously strong investment banking and investing and lending revenue growth of 18% and 23%, respectively, as well as a 40% year-over-year jump in net income (which, as my colleagues point out, wasn't entirely because of corporate tax reform). On the flip side, trading revenue has been mediocre for some time now, which has weighed on Goldman Sachs and its peers.
Altogether, Boeing, UnitedHealth Group, and Goldman Sachs account for 5,721 of the Dow's 25,307 points, as of Monday's close. That's 22.6% of the value of the index coming from just three components. It's no wonder why I suggest paying little attention to the Dow as a measure of economic and stock market health.