Why Do We Watch the Dow Jones So Closely When its Makeup Makes No Sense?

The Dow Jones Industrial Average (^DJI +0.60%) is a strange beast. With only 30 components, it can't possibly represent the scope of American stock markets as well as the broader S&P 500. Yet not only does the Dow follow the S&P fairly closely in any given year, it has actually outperformed the S&P on a longer timeline. No matter how much we might claim that the S&P is more accurate, it's still the Dow that we look to every day. After all, since it has 30 of the most popular stocks on the market, most investors probably have a stake in the Dow's performance. And since it only tracks 30 stocks, it's easier to figure out why the index moved in any direction on any given day.

But how much do the Dow's components really matter? Think about it -- right now, six financial companies account for more than a quarter of the Dow's daily momentum. Six tech and telecom companies, which together account for nearly three times as much market value as the six financial stocks, have less than half as much influence on the index's movements. To see how strange the Dow's share price-weighting scheme can really get, let's examine a few possible changes that might make sense for the blue-chip index, but would be almost incomprehensible in a weighting scheme like the S&P's where size matters most.

The retail switcheroo
Wal-Mart (WMT 0.39%) is by far the world's largest retailer, and it's also the Dow's sixth-largest component by market cap. But its share price keeps Wal-Mart in the lower third of Dow components by weight. We could swap it with Costco (COST 0.93%):

Sources: Finviz, Yahoo! Finance, SlickCharts.

Replacing Wal-Mart with Costco would boost the retail sector's representation, but retail is already a bit over-represented relative to its actual economic weight in the United States. It would also make the Dow more representative of the lifestyles of its investors -- the average Costco shopper has a household income of $85,000, while 20% of Wal-Mart's customers are on food stamps. But the Dow is supposed to represent the entire economy, not just the part preferred by the investing class. Costco, in fact, has a lower market cap than any of the seven retail-oriented stocks currently on the Dow.

Connecting the Dow to the cloud
As we've already seen, the Dow's six tech components are under-represented thanks to a tendency toward low share prices. We could replace Cisco (CSCO 1.02%), the Dow's lowest-weighted component, with salesforce.com (CRM +0.41%) to get some cloud-computing representation and enhance tech's stature on the index. How might that work?

Sources: Finviz, Yahoo! Finance, SlickCharts.

The cloud is certainly an important new subset of the tech sector, and adding Salesforce would help boost tech's value on the Dow to levels more appropriate to its actual economic importance. However, not only is Salesforce a fraction Cisco's size, its profitability is a mirage next to Cisco's (Salesforce has reported a net loss for the trailing 12 months). In addition, its free cash flow, while positive, is still a tiny fraction of Cisco's -- at current levels it would take Salesforce more than 15 years to generate as much free cash flow as Cisco earned over the past four quarters. It might help balance the Dow, but Salesforce wouldn't be a better representative for the tech sector than Cisco.

Boosting biotech
Health-care stocks don't get too much love on the Dow, even though the sector is one of America's most valuable -- financial, industrial, energy, and basic materials are all more heavily represented on the index despite accounting for lesser shares of the American economic pie. Part of that is due to Pfizer's (PFE 0.46%) low share price. The biggest of Big Pharma is third from the bottom on the Dow's weighting ranks, which means it exerts less influence than a number of companies a fraction its size. There are plenty of big pharmaceutical companies out there, but only a few are still based in the United States. Swapping Pfizer with biotech superstar Gilead Sciences (GILD +1.05%) might do the trick:

Sources: Finviz, Yahoo! Finance, SlickCharts.

The Gilead-for-Pfizer swap comes the closest of our three options to making sense from a market-cap standpoint. In fact, Gilead is the largest health-care component on the S&P 500 that is not also part of the Dow. However, this replacement would have made far less sense even a year ago, as Gilead's market cap and share price have both swelled 50% in 52 weeks on the back of monster sales of its new hepatitis C treatment Sovaldi. Pfizer, in contrast, has held up its share price with buybacks even as its market cap has declined by roughly 6%. The fortunes of Big Pharma can change rather quickly as drug patents expire, so while Gilead might eventually top Pfizer if the latter can't develop new blockbusters soon, it's not likely to hold the lead for the long term.

The Dow has retained its relevance with timely member replacements and clever choices over the past three decades. However, accurately tracking the market's moves may become impossible in time if America's largest and most notable publicly traded companies continue to trade at share prices that don't reflect their relative importance to the Dow. For a long time, the Dow was less important than many other indices. If its weighting system falls too far behind reality, it could become an afterthought again.