Derek Kravitz, Investment Analyst, shares information on the changes to the Dow Jones Industrial Average and the significance of those changes.
December Stock Market Update Transcript
Hi, everybody. This is Derek, the investment analyst here at Financial Services Advisory, with your December 2020 Market Update. If you’ve paid any attention to financial news media this year, you’ll notice that the two big topics have been coronavirus and the U.S. presidential election which just concluded. But sometimes amidst these big topics there can be smaller topics that are still relevant that sometimes don’t get quite the attention they deserve. One of those topics I’d like to discuss today is changes to the Dow Jones Industrial Average, or just simply the Dow, that happened earlier this year. I’m going to discuss what those changes are and why they’re significant.
First, let’s discuss what makes the Dow special. It was launched in 1896 by Charles Dow, and it has long held significance for Americans since then as being synonymous with overall stock market activity. When you hear your neighbor ask you, “Hey, did you see what the market did today? It was down over a thousand points,” they’re likely going to be referring to the Dow Jones Industrial Average. But despite this continued prominence, it’s important to understand that the Dow has a couple of key drawbacks.
The first drawback is that it is comprised of just 30 companies. Now, when this index was launched in 1896, comprising an index of just 30 large American companies would do a pretty good job at representing the entirety of American economic output. But today our economy is larger and more complex than ever, making it a little bit harder for an index of only 30 companies to really truly represent the entirety of American economic output today.
The second key drawback is that it’s a price-weighted index versus a capitalization-weighted index. Basically, what this means is that if a stock has a higher price per share it will have more influence on the Dow as an index. This is in contrast to a market capitalization-weighted index in which the total market value of a company is what dictates its influence on the performance of an index. Many professional investors, for these reasons, will opt to reference the S&P 500 or the Russell 3000 or other large capitalization-weighted indexes to gauge the overall performance of the stock market versus the Dow. Regardless of these drawbacks, the Dow’s enduring popularity means that we should stay up to date with any changes that happen to it.
So what exactly changed? Well, this past August S&P Global, the owner and operator of the Dow Jones index, disclosed that they were going to be changing three of the names in the Dow. It’s already newsworthy when one name changes hands, but three all at once I felt was pretty important. You have Salesforce.com, Amgen, and Honeywell coming into the index, while Exxon, Pfizer, and Raytheon exited. S&P Global disclosed that these changes were brought in part by Apple deciding to do a 4-for-1 stock split this past summer.
If you’re more interested in stock splits, FSA recently did a Technical Tuesday video on the topic that can be found on our website, FSAinvest.com. But in a nutshell, a stock split is where a company decides that they’re going to split one share into some number of new shares. In the case of Apple it was one share turning into four new shares. The price adjusts proportionately as well. So whereas Apple was about $400 pre-split, a 4-for-1 stock split meant that post-split it would be trading at about $100 per share. Now, in a price-weighted index, which the Dow Jones is as we discussed earlier, this meant that Apple only retains 25% of the influence as it did prior to the split. Apple’s stock split meant that technology exposure in the Dow ended up below where it should be. In order to fix this, Exxon would be replaced by Salesforce.com, yet another technology name added to the Dow.
This is just so symbolic of the changing U.S. economy. We used to be much more industrial and energy based, and this is just a clear example of that continued long evolution towards a more service and technology-based economy. Regardless of Exxon’s departure, Chevron will carry the energy exposure torch forward in the Dow Jones. We should expect that in a free market economy the winners of today will replace the winners of yesterday, and that is what’s happening here.
Still, the significance cannot be overstated. It wasn’t that long ago that Exxon was the largest company in the United States by market capitalization, only to have been surpassed in recent years by various technology companies. Economic trends will always be in a fluid and evolving state. It makes one wonder what the top sector in the Dow might be in a hundred years. It may be something we’ve never even heard of, just the same way if we time traveled back to 1896 and tried to tell Charles Dow that cloud computing would be a big part of his index. For now it’s just exciting to be living through market history.
And now for a quick portfolio update. With the election finally behind us, markets have one less thing to worry about. Traditionally election years, and all years, see November and December as positive months for the market. And at least in this way, 2020 has been a normal year. In fact, major market indexes were up better than 10% in the month of November. It was the Dow’s best month since 1987. We had built up some cash amid some market volatility prior to the election, and we redeployed that cash after the election. With market trends up and rising and seasonal tendencies positive, we are content to let the portfolios ride the bull wave.
For your December 2020 Market Update, this has been Derek, the investment analyst, here in Financial Services Advisory. We wish you and your family safe and happy holidays. Thank you.