Picture a Dow Jones Industrial Average
A steadily growing number of pundits support the additions of Apple and Google, and it sometimes feels like a campaign that's gaining traction. Making this big swap makes sense, too, at least on the surface. After all, these stocks are the bluest of blue chips. However, once you actually get down to it and crunch the numbers, the whole scenario frankly looks kind of scary.
Note: the Dow is a price-weighted index. To find out more about how the Dow works and to understand better how changes could affect the Dow, check out " What Moves the Dow Every Day . "
If it ain't broke, why fix it?
The folks adamant about the Apple and Google addition have a valid argument – these are two of the best and biggest companies out there. After all, Michael Phelps deservedly makes every list of top Olympians. All the "Top 100 Songs of All Time" rankings reserve a spot for "Stairway to Heaven," and no one talks about the classic all-time comedies without at least mentioning Caddyshack. In the minds of many people, the Dow is the stock market's "best of" list. And at the very least, it does headline some of the best from all the industries. With an index, according to its website, that "represents a select group of prominent U.S. companies," it stands to reason that the most prominent companies should be included. After all, what other mechanisms could the editors resort to?
Put another way, Apple's market cap makes it about the 20thlargest economy in the world. A company that enormous touches a variety of industries. Retail sector earnings, for instance, will in part reflect Apple's strength. It also carried a host of suppliers to huge gains in recent years, and drives a lot of the tech sector. As Apple goes, so will a huge part of the overall market. Its revenue is almost 1% of U.S. GDP all by itself!
And few would deny that Apple would represent the tech sector itself better than, say, Hewlett-Packard
Google, on the other hand, revolutionized the way in which we interact with the Internet, dominating one market while competing with Apple in the fastest-growing area of another (mobile). Obviously, as a huge company, it can affect its peers much like Apple. If Google's traffic remains high, then companies can benefit from its powerful, targeted advertising. Other companies, like LinkedIn, seek partnerships to promote their business. And Google's success provides some insight into consumer demand.
But the bigger argument for Google is the burgeoning dot-com industry overall. Sure, the industry struggled somewhat after the bubble burst in the early 2000s, but companies such as Facebook, Yahoo!, and Groupon still generate a ton of revenue through online commerce and traffic. Some representation of that aspect of the U.S. economy -- especially by a company with exposure in other areas -- makes a lot of sense.
The new Dow
But as often happens, theory and a rational argument do not always convert into reality.
To start, I took a look at how the decision would have affected the Dow if we made it three years ago. History does not always repeat itself, nor does it always provide an exact analogy, but it can offer some insight into how things could shift. The Dow last made a change in June 2009, adding Cisco and Travelers after the financial crisis nearly destroyed both GM and Citigroup. So for consistency's sake, I used the same date to run the numbers on how the Dow would differ today had the editors also swapped in Apple and Google while booting Hewlett-Packard and Alcoa
Take a look again. The Dow would have risen over 60% in the roughly three years since the editors made the switch, or almost twice the Dow's actual growth of 30%. Remember that criticism the Dow attracts for its discrepancy from the S&P? Keep it coming, and then some. The revised index would have absolutely trounced its previous high of 14,164, would sit at almost 15,400 as of July 23, and flirted with 16,000 earlier this year.
Yes, you read that correctly: Make the change then, and the Dow would be crushing its all-time highs. In fairness, adding both Google and Apple in 2009 seemed out of touch with this vision of representing the broader U.S. markets. After all, companies like Groupon and even Facebook had yet to burst into the public markets, which made Google more of an outlier. Apple had a more legitimate case, although the newly released iPhone and iPad concept had yet to develop into revenue that now drives 75% of Apple's business. The death of the PC industry had yet to plague Hewlett-Packard, and Alcoa represented a stronger U.S. manufacturing sector.
Today, those arguments disappear. Hewlett-Packard continues its freefall, and manufacturing no longer underlines such a large portion of U.S. GDP. Apple is, of course, the world's largest company, and Google represents a steadily growing dot-com industry. So how would the Dow look if it made those changes today? (Data as of July 24).
Because of the high price of Apple and Google, the two stocks would account for more than 40% of the Dow's daily movement, which would cause massive daily changes. On April 13, shares of Google soared more than 4% after it revealed incredible profits. A couple of weeks later, Apple hit nearly 9% gains after it smashed expectations as well. Just those two days alone would push an otherwise flat Dow up more than 300 points!
That same scenario could keep the Dow flat if Pfizer, General Electric, Cisco, and Bank of America all went bankrupt while the rest of the Dow traded even. And Apple's and Google's combined weights would match that of the bottom 22 components, including giants General Electric and Wal-Mart.
This touches on the underlying problem with adding such high-priced (and somewhat volatile) stocks to the Dow. Yes, companies like Apple and Google do reflect a huge part of the overall markets, but their huge size would practically overwhelm the Dow's allocation. Apple and Google drive the markets, but not quite to the extent they would drive the Dow.
Should the switch be made?
We're discussing complete hypotheticals at this point. Apple and Google would make a great fit for the Dow, but the index has yet even to hint at possible changes to the current construction. And Dow Jones Indexes Executive Director John Plesbo spoke on this exact issue: "Apple certainly qualifies in every respect except one -- price." The question, then, is not whether Google and Apple theoretically "belong" in the Dow. The real question is whether the Dow needs the additions so badly it should shake up its entire formula.
That question boils down to whether the Dow can reflect the overall markets -- its stated purpose -- without adding Apple and Google. As currently constructed, the Dow provides an insight into how the market performed in the past -- 10 years ago, 50 years ago, even 100 years. Switching the formula, and losing that historical context, would imply that the Dow would be skewed versus its historical average without adding Apple or Google. As I wrote previously, this is simply false. With more than a 90% historical correlation with the S&P 500, the Dow does a decent job. It might need minor changes to reflect changing market demographics, but not a complete overhaul of its formula.
Apple and Google, in theory, would absolutely enhance the Dow's ability to track the markets' progress. And the Dow, as admitted even by the chairman of the Dow Indexes, could very well need a change soon. But it doesn't need to change its entire formula, but to readjust and optimize its components' effect. As Prestbo pointed out: "Everybody is in love with Apple because it keeps defying gravity. That doesn't mean the Dow isn't doing its job of reflecting the market."
And that's the key. We don't need a Dow that changes 100 points every day. We don't need a Dow that flirts with 16,000 in a still-recovering economy. We just need a Dow that reflects the overall markets, and maybe a Dow that keeps its historical perspective. It might be unfortunate, but that means we need a Dow without Apple and Google.
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Fool contributor Will Chavey owns no shares of the stocks mentioned above. The Motley Fool owns shares of Apple, Google, Facebook, Bank of America, Cisco Systems, LinkedIn, and Citigroup. Motley Fool newsletter services have recommended buying shares of Facebook, LinkedIn, Apple, Google, Pfizer, and General Motors and creating bull call spread positions in Apple and Wal-Mart Stores. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.