The Dow’s Changes Make Sense
Thursday, September 12, 2013
Charles Rotblut, CFA
AAII Journal Editor

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Market Barometers: Stock Indexes
A look at indexes and their weighting methodologies.

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The 10 highest yielding Dow components.

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 45.5%, up 10.0 points
  Neutral: 29.9%, down 3.3 points
  Bearish: 24.6%, down 6.7 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »




Recently, a number of our members have been solicited for new and renewal subscriptions by a group calling itself the ASSOCIATED PUBLISHERS NETWORK (APN). We do not have any relationship with this group.

This group has a history of deceptively targeting magazine and newsletter subscribers as well as trade and association membership groups. In the American Association of Individual Investors’ (AAII) case, they look to sell a one-year subscription of the AAII Journal for $69.95 with instructions to send payment to an address in Henderson, NV. The Internet is filled with many citations of this group presenting inflated subscription offerings for a wide range of publications.

The AAII does not hire outside agencies to solicit new members or renew memberships. Any renewal or new membership postal mailing from Associated Publishers Network is a ploy and this group is in no way authorized by or affiliated with the AAII. This deception was brought to our attention by several AAII members and we thank them for taking the time to contact us. If you subscribe to other publications, be on the lookout and make sure that you are dealing directly with a known publisher.

If you are ever unsure about your renewal status you can go to AAII.com, log in and then click on the My Account tab found near the top-right corner of our home page.

It’s not often a change is made to the Dow Jones industrial average, and it’s even rarer to see three out of the 30 components replaced. This is what makes Tuesday’s announcement interesting. Goldman Sachs (GS), Visa (V) and Nike (NKE) will replace Bank of America (BAC), Hewlett-Packard (HPQ) and Alcoa (AA) after the close of trading on September 20, 2013. This is the first time three stocks have been replaced in the average since April 2004.

The Dow’s stated objective is “to represent large and well-known companies.” The average covers all industries with the exception of transportation and utilities. This objective is what makes changes to the Dow a subject of conversation and debate. Specifically, why was one stock added over another?

In contemplating what should and not be included, it is important to consider two important characteristics of the average. The first is the use of price weighting instead of market-capitalization weighting, which the S&P 500 uses. Due to their low share prices, Alcoa, Bank of America and Hewlett-Packard have a combined influence of 3% on the Dow’s movement, according to David Blitzer, the chairman of the index committee at S&P Dow Jones Indices. (Alcoa’s $8.15 price equates to about a 0.4% weighting.) Conversely, International Business Machines (IBM) has an approximate 9.5% weighting in the average, thanks to its $190.73 share price. The inclusion of Goldman Sachs and Visa dilutes IBM’s influence and makes the Dow more balanced due to the two stock’s respective share prices of $163.15 and $185.06.

The use of price weighting does mean some companies will be excluded because of their share prices. Two notable examples are Apple (APPL) and Google (GOOG), which trade at $472.69 and $893.06, respectively. The inclusion of either would have greatly influenced the future performance of the Dow.

The second is that the average is not intended to solely hold the 30 largest U.S. stocks. Rather, the Dow is intended to be a representative list of blue-chip companies. Membership in the average is determined by a committee of five individuals, two from the Wall Street Journal and three, including David Blitzer, from S&P Dow Jones Indices. Blitzer told me the committee starts with the S&P 500 and then considers various factors, including which industries are and are not represented in the average. Though the average’s methodology does provide guidelines, it leaves the door open for subjective decisions.

The Dow’s methodology states, “While stock selection is not governed by quantitative rules, a stock typically is added to the index only if the company has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors. Maintaining adequate sector representation within the indices is also a consideration in the selection process.”

Given these two characteristics, the committee’s decisions become clearer. Goldman Sachs has a higher share price than Bank of America and eliminates the overlap caused by having both Bank of America and JPMorgan Chase in the average. Visa focuses on payment processing networks and technologies, while a significant portion of Hewlett-Packard’s business overlaps with Intel (INTC) and Microsoft (MSFT). Nike is the average’s first footwear company and replaces a company, Alcoa, that is comparatively small both in terms of share price and market-capitalization size.

Notably, none of the changes will have influence on the Dogs of the Dow as it currently stands. Neither Alcoa, Bank of America nor Hewlett-Packard ranked among the average’s 10 highest-yielding stocks.

The weightings within the Dow will be reset after the market’s close on Friday, September 20. At that time, the Dow’s divisor will be recalculated based on the average share price of the updated list of 30 stocks. This divisor will then determine how much influence each stock will have going forward. The level of the Dow will not change, though its movement going forward will, with IBM having less influence on the average’s performance.

Concerning the use of the Dow Jones industrial average as a portfolio, the SPDR Dow Jones industrial average ETF (DIA) tracks it. However, the Dow is intended to be a representative list of blue-chip companies. It lacks both the size and the diversification of the S&P 500. Thus, while the Dow is an interesting and oft-cited benchmark, it lacks the investment appeal offered by larger stock indexes.


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The Week Ahead

I will be speaking to our Santa Barbara/Ventura chapter on Thursday, our Orange County chapter on Friday and our Los Angeles chapter on Saturday. Not in Southern California? Visit our local chapters page to find a meeting near you.

We will get our preliminary look at earnings season with seven S&P 500 companies announcing their quarterly results. Included in this group of early reporters are Adobe Systems (ADBE), which will announce its results on Tuesday, and FedEx (FDX) and Oracle (ORCL), which will announce their results on Wednesday.

The Federal Open Market Committee (FOMC) will hold a two-day meeting, starting on Tuesday. The meeting announcement will be released at 2:00 p.m. ET on Wednesday, along with forecasts from the committee’s members. Chairman Ben Bernanke will then hold a press conference at 2:30 p.m. ET. It is widely expect that the FOMC will give some indication of its plans to start tapering bond purchases, though the timing and the magnitude of the tapering is a subject of much speculation.

Elsewhere on the economic calendar, the September Empire State manufacturing survey and August industrial production and capacity utilization will be released on Monday. Tuesday will feature the August Consumer Price Index (CPI) and the National Association of Home Builders September housing market index. August housing starts and building permits will be released on Wednesday. Thursday will feature August existing home sales and the September Philadelphia Fed Survey.

Three Federal Reserve officials will speak publicly on Friday: Kansas City president Esther George, St. Louis president James Bullard and Minneapolis president Narayana Kocherlakota.

Friday is a quadruple witching day, meaning both option and futures contracts expire.

AAII Sentiment Survey

Optimism jumped to a two-month high in the latest AAII Sentiment Survey. The rise occurred as both neutral and bearish sentiment declined.

Bullish sentiment, expectations that stock prices will rise over the next six months, spiked upward by 10.0 percentage points to 45.5%. This is the highest level of optimism since July 11, 2013. It is also the first time in five weeks and just the second time in the past seven weeks that bullish sentiment is above its historical average of 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, declined 3.3 percentage points to 29.9%. This is the second time in four weeks that neutral sentiment is below its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 6.7 percentage points to 24.6%. The level of pessimism was last lower on July 25, 2013. The historical average is 30.5%.

Since hitting a three-month low of 29.0% on August 22, bullish sentiment has rebounded by a cumulative 16.5 percentage points. This upward move is not surprising, given the swings in sentiment that have occurred over the past several months. Even with the increase, bullish sentiment remains within its typical range of readings.

This year’s fourth seven-day streak of gains in the S&P 500 coincided with our survey period of Thursday through Wednesday. The market’s resilience and its rebound from its August lows have encouraged individual investors. Nonetheless, macro uncertainty including the Federal Reserve, Washington politics, market valuations and the evolving situation in Syria continue to keep AAII members’ sanguinity for stocks in check.

This week’s special question asked AAII members what economic trends they are currently watching. Interest rates topped the list, with 24% of respondents saying they monitor them. An additional 13% said they are watching Federal Reserve policy. The employment picture came in second, listed by 19% of respondents. Housing and real estate was a close third, named by 18% of respondents. Nearly 7% of respondents said they are monitoring the situation in Syria, even though we did not ask about geopolitics.

» Take the sentiment survey