February 2024
As an investor you probably have often asked yourself, should I be more concerned about the Dow Jones Average or the Standard & Poor 500 Index. Both provide a benchmark for large US companies. Neither includes foreign countries, although most large companies get a significant portion of their revenue from foreign operations. As one example, despite all the Golden Arches we see around us, 70% of revenue for Dow member McDonald’s come from outside the US.
The Dow Average has been around since the late 19th century and is the most well recognized index globally. Since there are almost 4,000 publicly owned US companies, a good question is how can the performance of just 30 super large companies, all rated blue chip for high quality, be meaningful? Dow members are chosen by sector to try to mimic the economy but a big flaw is it is weighted by share price. At the close of each business day the share prices of the 30 companies are totaled. The total is then divided by a number that currently is around 0.151727, less than one which means it’s actually a multiplier. Why is there a need for a divisor, and why such a crazy number? The divisor is needed to “normalize” the average. It smooths out impact events like stock splits, spin offs and dividends. For example, Walmart is about to split shares three to one. The per share price will drop by 67% even though there’s really no change in value. The divisor’s craziness is due to the accumulative effect of offsetting the impact of such events over the years.
It doesn’t happen that often but an adjustment to the divisor is needed when there is a change in the makeup of the 30 companies. In 2018 General Electric, the last original Dow member, was replaced by Walgreens. Imagine the impact on the average when a drugstore chain replaces a diverse industrial giant. In 2018 a GE executive noted that dropping GE was not surprising because its price was down some 55%. He said his company was dragging the Dow down with it. That raises the question of how meaningful is a benchmark which can be raised by changing one of its components.
The company with the highest Dow stock weight is Unitedhealth Group at 9%. Microsoft and Goldman Zachs are tied at 7%. In the S&P, Microsoft is at the same 7%, Unitedhealth at 1% and Goldman Sachs .3%.
The S&P dates to 1957. It includes 470 leading US companies plus the 30 that are in the Dow. Obviously it has a bigger scope than the Dow and provides a better representation of the overall stock market. The S&P also needs a divisor to offset the same events as the Dow. It’s based not on the stock price of its members but their market capitalization, which is the share price times the number of outstanding shares. The 500 companies make up 80% of the total US stock market capitalization. The Magnificent Seven (Apple, Microsoft, Amazon, Alphabet, NVIDIA, META and Tesla) are just 14% of the companies in the S&P but determine 28% of the index. Only the top 14 companies have a weight above 1%. GE is in the S&P and has a weight of .4%. At the bottom of the list of the 500 companies are Ralph Lauren and FOX Network weighing in at 1/100 of 1 percent.
Despite the differences in the makeup of two benchmarks and how they are calculated on most days the Dow and the S&P move in the same direction. Both hit all-time new highs this month. Where there are differences is in the 10 year annual return, which for the Dow is 9.1% while the S&P is 12.5%. The Dow usually holds up better in a down market because of its super large blue chips, while the S&P usually does better in an up market because of a tilt toward growth versus value.