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Home > Investing > Why The DOW (DJIA) Is Outperforming

Why The DOW (DJIA) Is Outperforming

January 24th, 2012 Leave a comment Go to comments

The Dow Jones Industrial Average (DJIA) or sometimes the DOW, is the most tracked and oldest stock index in the U.S. As an index, it’s a pretty poor one by modern standards. There are downsides to any kind of index, but the DJIA has a few major flaws. First, it only contains 30 stocks whereas modern indexes contain hundreds (from its original 19th century version which contained only 12 stocks, I guess it’s an improvement). Second, it’s market weighted by stock price, not by market cap or some other weight such as sector weight.

For 2011, this imperfection led to outsized performance…

A weight by stock price means that IBM (stock price ~$180) gets a much larger share in the DJIA instead of ExxonMobil ($87) simply because the stock price is a larger number! ExxonMobil is a far larger company and one could make the case the its sector (energy) would necessarily be a larger and more important component of the economy than technology. But in the eyes of the DJIA, IBM gets the nod.

Dow Jones has made adjustments to the indexing methodology over the years. For example, if IBM decided to do a 3-1 split, this wouldn’t cause a drop in IBM’s weighting as this doesn’t affect the value of the company or its place in the index. So, Dow Jones has rightly updated its methodology to account for this. However, if IBM decided to spin off a large division this type of event does affect the valuation and likely would cause the index managers to consider adjusting IBM’s weighting for the portion of the company that is leftover. In some situations, the board could even decide to drop the company altogether if it felt the change affected the overall diversification of the portfolio.

The DJIA is overall pretty stable, changes don’t occur that often.

Seeds Of Out-Performance

The 2011 out performance of the index can be attributed to the smashing returns of the (3) largest components.

The top 3 companies in the DJIA, IBM, Chevron (CVX) and McDonalds (MCD) have large share prices and together make up almost 25% of the entire index. These (3) companies over the past year have handily beat the index average by a large margin (about 20-30% return for IBM and MCD and CVX – the 2011 DJIA return was about 5%, all returns do not include dividends).

But, wherever there are winners there are losers. Losers such as Alcoa (AA) and Bank of America (BAC) have been a major drag on the index recently (you could have easily beat the market last year simply by eliminating financials in your portfolio – my portfolio benefited as well). Since the “winners” have a much larger weighting and their returns were outsized, the DJIA has pulled away from the S&P500 Index. The S&P500 index uses market cap weighting, which puts ExxonMobil as No. 1, not IBM. McDonalds, at #3 isn’t even in the top10 of the S&P500 index. It’s over 30% return for 2011 really juiced the DJIA.

In 2011, the DJIA was up over about 5%, the S&P500 index was essentially flat at 0.0%.

The Outlook For 2012

Over long periods of time, the DJIA doesn’t perform that much different than other major market averages. The DJIA does have a head start over the S&P500 because it’s Dividend Yield is about 33 basis points higher. That doesn’t sound like much, but compare that to the 10 year U.S Treasury bond yield of 2.00% and a 1/3% difference is big.

No one can predict the future, but I would expect this out performance to end simply because 2012 could be the year that the U.S. gets some glimmer of real sustainable growth. It won’t take much, even a ‘whisper’ of potential growth will turn the beaten down DJIA components into winners. It’s already happening! The risk trade is on! Bank of America (BAC) and Alcoa (AA), 2011’s losers are the winners in January 2012, up 31% and 15% respectively so far in 2012 (Jan 24th)!

When these low price losers gain, this isn’t good news for the DJIA.

As of this writing on Jan 24th, the S&P500 is winning! 4.5% gain for the S&P500 index versus 3.8% for the DJIA.

We’ll see how it works out over time.

How To Buy The DJIA

You might be thinking, how can I invest in the DJIA? S&P500 index funds are a dime a dozen. One way to invest in the DJIA is to buy so-called ETF Diamonds or the SPDR Dow Jones Industrial Average ETF (ticker symbol: DIA) by State Street Global Advisors.

The neat thing about DIA is that is pays dividends monthly! None of the other major market index ETFs that I found pay out dividends this way.

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