In statistics, the Pareto rule suggests that generally 80% of effects come from around 20% of potential causes. This is known as the 80/20 rule and in the business world it is typically used to suggest that approximately 80% of revenues come from around 20% of customers, but it also certainly applies to the Dow Jones Industrial Average (NYSEARCA:DIA).
The Dow topped back on Dec 31 but is now having a hard time making new all time highs as it still resides over 200 points from that recent top. Almost all the other major indices have already made new highs, though, so why can’t the Dow?
Dow Jones Industrial Average
First things first, the Dow is only made up of thirty companies. This makes it susceptible to each individual company’s performance much more so than a larger index such as the S&P which includes 500 components.
Secondly, most other indices are also market cap weighted throwing another wrinkle in the Dow’s calculations compared to other benchmarks, but there is more going on than just its price weighting or its small amount of components.
An even larger underlying and troubling trend is also occurring that is the primary culprit of the Dow’s underperformance. I wrote about the Dow’s faulty construction in articles titled, “The Dow Committee Again Gets it Wrong” and “The Dow’s Flaws Uncovered.”
80 / 20 Rule Indeed
Check out the data below that shows the Dow’s components sorted by weights.
The top five stocks in the Dow make up 1/3 its price.
Furthermore, the 20 largest stocks in the Dow make up over 85% of the Dow’s total calculation (highlighted in green). In other words, the smallest 10 of the Dow’s components barely move the Dow’s needle when they rise and fall as they make up only 15% of the Dow’s total price.
For instance, Cisco, the smallest Dow component, could fall to $0 and the Dow would only be affected negatively by 0.9%.
J.P. Morgan, the largest bank in America by assets, and the 8th largest bank in the world, would only bring the Dow down 2.4% if it went bankrupt.
In contrast, if Visa were to go bankrupt, the Dow would fall over 8.7%, even though in the real world Visa is a much smaller company than most of the other Dow components.
These nuances are primarily because the Dow is a price weighted index (as opposed to market cap weighted). But, they also hint at some of the reasons the Dow is having trouble rallying to new all time highs along with most other markets.
The companies that are still able to make new highs, are small components in the Dow, whereas those that have been performing weaker are much larger components.
Now check out the next chart which shows amongst other things the number of Dow companies making new 52 week highs shown by the middle section.
That section in green in the middle shows less and less Dow components are making new 52 week highs even though the Dow itself does. When the Dow last made a new all time high on December 31, 2013 it was accompanied by 11 Dow components, down from 13 in May.
The declining trend continues through today with only 6 companies making new highs in March and warns the uptrend is being propped up by fewer and fewer Dow components. Less stocks are participating in the uptrend.
The bottom section supports this as well. That data shows that the average Dow stock is now only at 70% its 52 week price range. In other words, near previous tops, the average Dow component was closer to making new 52 week highs, above 85% its 52 week price range, but today the average Dow component’s price is farther from a new high, down to 72% at March’s peak and 70% through this week.
Less Support from Components
The May 2013 high saw the most breadth with 13 Dow components making new 52 week highs along with the market. That number was only at 11 at the December 31 all time high and sits now just at 4 companies.
A further look into the numbers shows those four companies that are still making new all time highs are Caterpillar (NYSE:CAT), Johnson & Johnson (NYSE:JNJ), JP Morgan (NYSE:JPM), and Microsoft (NYSE:MSFT), but a glance back at the weightings, however, show that only two of these companies are even in the top ten of the thirty, and none of them are in the top five.
Together their components make up only 12% of the Dow’s total move.
In order for the Dow to also make new highs, it will need Goldman Sachs (NYSE:GS), IBM (NYSE:IBM), and Boeing (NYSE:BA), which are all down over 5% from new 52 week highs, but make up over 18% of the Dow’s weight, to resume their leadership and carry the Dow higher.
The ETF Profit Strategy Newsletter focuses on the data that actually drives the markets. Right now, the Dow’s calculation nuances and declining breadth will likely keep it from joining the other markets in making new all time highs. We follow the Dow and all the other major asset classes to help subscribers stay on the right side of the markets in our Technical Forecast, Weekly ETF Picks, and Monthly Newsletter.