While we just noted the insanity of chaotic market shifts in the face of the broad market's lackluster performance, Nic Colas, of ConvergeX Group, goes one step further. Dismantling the 592 point rally in the archaic (yet seemingly so important to mom and pop) Dow, Nic shows that the majority of this move was simply thanks to just two stocks (IBM and MCD). The 5.1% outperformance of the Dow, in the face of the S&P's blank, is the seventh year of the last twelve (we suppose thanks to the lower financial exposure) but the weighting scheme seems to be so rife for 'help' - especially with blue-chip names so easy to defend for every long-only manager in the world, that it seems we should all thank Mr. Buffett for another good year on the Dow. On a less tin-foil-hat basis, Nic points out that confidence in the business models of the Dow names may have something to do with the remarkably sanguine perspective the sell side has on the earnings predictability of the companies in the index.
He Ain’t Heavy, He’s My Stock Index
Summary: The Dow is up 592 points on the year, and just two stocks represent more half that entire gain – IBM (173 points) and McDonald’s (122 points). That’s a function of the way the Dow Jones Industrial Average is constructed - weighted by stock price rather than market cap - as well as the strong performance of these two stocks (MCD up 28%, IBM up 24% YTD). The rest of the names that contributed to the Dow’s 5.1% return this year-to-date are: Chevron (75 pts), ExxonMobil (50 pts), Boeing (42 pts), Home Depot (36 pts), Kraft (30 pts), Wal-Mart (29 pts), Pfizer (23 pts) and Coca-Cola (23 pts). This is a useful snapshot of what kinds of stocks worked in 2011 – exporters, energy and consumer names, for example. And also consider that the Dow stands to trounce the S&P 500 this year by as much as 500 basis points, largely due to its lower weighting in financials.
Modern indexing is a multi-billion dollar industry that largely owes its existence to one man – Charles Dow, of “Dow Jones” fame. It was he who created one of the first modern stock market indices, tracking the transport stocks. This was in the 1890s, when “Transport” pretty much meant “Railroads.” After that he moved onto the broader market, predominantly industrial stocks, and the Dow Jones Industrial Average was born. The fact that index provider Dow also published a newspaper – what would become The Wall Street Journal – certainly helped popularize the approach of using an index as a proxy for market health and direction.
The funny thing about the Dow is that it is weighted by stock price – the higher the price of stock the more influence it has on the index. The origin of this methodology was Charles Dow’s approach to index creation: take all the companies you want in the index, add up their stock prices, and divide by the number of companies you are tracking. It is only marginally more complex now, as stock splits and dividends get included in the calculation. The basic process is unchanged from the 1890s.
And even if you snicker at this archaic approach versus more modern “Capitalization weighted” indices such as the S&P 500, the results this year are noticeably better. A few points on this:
- The Dow closed yesterday with a 5.1% year-to-date gain, far ahead of the S&P 500 which isn’t even in the black yet (-0.3%).
- The Dow has beaten the S&P 500 in seven of the past 12 years (see above graph). Importantly, it outperforms in every down year (2000, 2001, 2002, and 2008) since the bursting of the dot-com bubble in 2000.
- The source of the Dow’s 592 point gain this year is most due to 2 names: IBM and McDonalds, which together have added 295 points this year, or half of the index’s advance.
- The other 10 names of the 30 that represent the entire move in the Dow are Chevron (75 pts), ExxonMobil (50 pts), Boeing (42 pts), Home Depot (36 pts), Kraft (30 pts), Wal-Mart (29 pts), Pfizer (23 pts) and Coca-Cola (23 pts).
- The other 20 names in the Dow essentially cancel each other out. It may be the Dow 30, but only ten really mattered this year.
The reasons for the Dow’s outperformance are not hard to find. The financial sector has been a tough place to be in 2011, and the S&P 500 currently has a 12% weighting in a group that is down 18% on the year. The financials names in the Dow – JP Morgan, Bank of America, Traveler’s and GE – are down an average of 8%, and their collective weighting is 7.2% of the index. And there is also in the intangible of having a handful of super-cap names, each of which is an acknowledged and long-time leader in its industry, to support the names in the Dow. No, that hasn’t quite worked out for some of the financial names – BA is down an astounding 59% year to date – but at least its weighting in the index declines with the stock price. IBM at an 11% weight (and $182 stock price) dwarfs BAC’s weighting in the Dow at 0.33% (with its $5.47 stock price).
This confidence in the business models of the Dow names may have something to do with the remarkably sanguine perspective the sell side has on the earnings predictability of the companies in the index.
The above table shows that the most pessimistic analyst in terms of earnings expectations for the 30 companies of the Dow and how that estimate varies from the consensus. Not much, as it turns out – about 9% in terms of 2012 expectations. We’ve added some other names to this list (Apple, Google, and Oracle) to give a bit of a wider perspective. But with one exception – AT&T (likely due to the recently abandoned merger) the most pessimistic analyst is very close indeed to the average expected future earnings as defined by the consensus.