The index committee that runs the S&P Dow Jones Indices is making changes to the stocks components within the Dow Jones Industrial Average (DIA). Instead of being a broad measure of the U.S. stock market, the changes appear to be more about controlling the DJIA's price movements than any real fundamental reasoning.
How does one explain dropping a much larger company that has a much bigger consumer footprint like Bank of America, for a much smaller, much more specialized company from a similar industry, such as Goldman Sachs?
Based on S&P's Index Committee Chairman, David Blitzer, it is explained by reminding us, "There's no intention to pick winners. Adding a stock or dropping a stock is not an investment recommendation. It is done to improve the index and make it a better indication of the market overall."
But actions speak louder than words my friends and the Committee's actions are raising extremely large red flags for this market strategist. I fail to see any "better indications of the market overall" in the upcoming move.
The reason these particular stocks are being added is because of their significantly higher price points and thus larger upside potential for the Dow's price. Period.
A Bank for a Bank?
There will soon be zero traditional banks left in the Dow Jones Industrial Average. Citigroup was removed in 2008 (likely for similar "too low a share price" reasons) and when Bank of America is booted the weekend of Sept 21, there will be zero traditional banks remaining.
Not only are there now going to be zero traditional banks, there are going to be two investment banks, the other one JP Morgan (JPM). (If you think JPMorgan Chase is a traditional bank then please review the "London Whale" debacle).
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More so, there will now be two credit card transaction processing companies, with American Express (AXP) the already existing one in the Dow.
Are we really supposed to believe that the Dow will be more representative of the market with zero traditional banks (when combined hold over $10 Trillion in assets) but instead holding two investment banks and two (of only four major) credit card transaction companies? Last I checked, traditional banking was still a much larger market than investment banking or credit card transactions/servicing.
Below are some facts that should make you scratch your head when trying to rationalize Bank of America's boot and Goldman Sach's and Visa's inclusion (especially when you consider that JPMorgan and American Express are already in the Dow):
Based on full year 2012 numbers, Bank of America has assets over $2 Trillion. Goldman Sachs has around $900 Billion in assets. Visa has a much smaller $40 Billion in assets. Of note is that Wells Fargo's (also not in the Dow) assets (WFC) are over $1.4T.
Bank of America has revenues over $100 Billion. Goldman Sachs has around $34 Billion in revenue. Visa's revenue is only around $10B. Wells Fargo has over $91 Billion in revenues.
Bank of America has a market cap around $157 Billion. Goldman Sachs's market cap is around $77 Billion. Visa's market cap is $119 Billion. Wells Fargo's market cap meanwhile is over $225 Billion.
As the fictional character Sherlock Holmes is quoted, "When you have eliminated the impossible, whatever remains, no matter how improbable, must be the truth". Anyway you slice it Bank of America (and Wells Fargo) is at least two times larger than Goldman Sachs and seems to be "a better indication of the market overall", using the committee's chairman's words. Compared to Visa, it is simply multiples times larger.
It is impossible to rationalize that Goldman Sachs and Visa are more representative of the market than Bank of America (or Wells Fargo), and that means there must be another truth.
The Real Reason for the Dow Change
Goldman Sachs is the 8th largest holding in the largest bank ETF, the Financial Select Sector SPDR (XLF). The largest financial company based on the S&P sector weightings is Wells Fargo. Was it even considered for the Dow inclusion instead of Goldman Sachs or Visa?
In contrast, Goldman Sachs has a share price over $160, and Visa has a share price over $180.
In what may be a sure sign of performance chasing, the primary reason Bank of America was dropped (and Alcoa and Hewlett Packard), was because its price is too low to have much impact on the Dow due to the way the Dow is calculated. Goldman Sachs and Visa however will have major effects on the Dow going forward.
As a price weighted index, mathematically the companies in the Dow that have higher share prices have much larger effects on the index's price movements.
For instance when Goldman Sachs goes up 5%, its price moves up $8; when Bank of America goes up 5% its price moves up only 80 cents...having approximately 1/10th the effect on the Dow's price. By adding Goldman and Visa, the Dow Industrials will feel the effects of these two company's price movements much more significantly.
Needless to say in a rising market, the Dow would much rather have higher priced components, making the Dow rise faster and farther. The drawback is this also leaves open the risk of having a larger negative effect during a declining market.
The Committee Chairman admitted such in a roundabout way when he commented on excluding very high priced companies such as Google (GOOG) and Apple (AAPL) from the Dow. "The prices of their stocks are so high that putting Google in would completely distort the index and it wouldn't work".
The Reality of the Situation
All three of the companies that are being dropped from the Dow have the three lowest prices of any of the 30 Dow components. Coincidence? No way.
The table of the current 30 Dow components below puts this reality into perspective and is why General Electric (GE), the only original Dow Industrial Component remaining, should be worried that it will soon be dropped by the Index.
Either that or the company will likely need to have a reverse share split to take its equity price comfortably over the $70 mark, the current median price for the 30 Dow Components.
ANALYZING DJIA COMPONENTS
Intel (INTC) and Cisco (CSCO) should also be on the lookout for a letter from a Dow Committee that is much more interested in the optics of a higher Dow price than a true representative average of American companies.
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