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An Index to the Indexes
by   Mark Wade  

When the rumor surfaced in July that Apple might be added to the venerable Dow Jones Industrial Average, a strange thing happened: Apple’s price rose on the news. One might think that Apple, the very epitome of a modern, 21st-century corporation, might have nothing to gain from joining the Dow, which dates back to an age when investors followed their stocks via tickertape rather than online portfolios.

But still, the stock rose by 2.6 percent on the day the rumor was printed by several reputable publications, following a supposition by the investment firm Sanford Bernstein that Apple might be getting ready to join the Dow. The Dow’s basket of 30 massive stocks may not be the watchword for the equity market that it was back in the gray-flannel-suit days, but it still is one of the watchwords of the investing community. It is still capable of not just making news but of affecting the markets.

The Dow Jones industrial average dates back to a time before computers, when the easiest way to evaluate the overall health of the market was to examine a small slice of its biggest stocks. It started back in 1896, when it consisted of 12 stocks – one of them, General Electric, survives in the Dow to this day. The very first reading had the Dow sitting at 40.94. The index expanded to 30 stocks in 1928, and for most of the 20th century it served as the leading barometer for the nation’s stock market.

Standard & Poor’s, a longtime financial information company, introduced its index of 500 stocks in 1957. Although the stocks in the S&P 500 are all large-caps, they are not, as is commonly thought, the 500 largest stocks in the nation. The companies are chosen by a Standard & Poor’s committee, which attempts to balance them by industry so that they give the best possible snapshot of the equity universe.

One important difference between the Dow and the S&P is that the Dow stocks are weighted by share price, while the S&P stocks are weighted by market cap. If Apple were to join the Dow, with its share price of over $600, it would overwhelm the rest of the index, providing as much weight as the bottom half of the companies (as measured by share price) combined. Most pundits assume that Apple would need to split its stock before it entered the Dow. That is probably the factor that drove Apple’s price bump.

By contrast, even though Apple has the largest market cap in the world, it accounts for just over 4 percent of the S&P 500. All together, the S&P 500 make up about two-thirds of the total value of American stocks.

The last time the Dow made a change to its components was back in 2009, when Cisco Systems and Travelers Corp. were added, while General Motors and Citigroup were dropped. GM was at that point entering bankruptcy protection, while Citigroup was avoiding bankruptcy by taking a $45 billion taxpayer bailout. (Ironically, Citicorp and Travelers had merged in 1998 to create Citigroup, although Travelers was spun back into its own company in 2002.)

But the S&P changes components all the time, because its companies get acquired or spun off or because of other changes. There were nine components switched out of the S&P 500 through the first eight months of 2012 alone.

With the breadth of companies it tracks, the S&P 500 has definitely replaced the Dow as the investing barometer of choice. There are around 200 different S&P 500 index funds, as well as $6 billion invested in products such as ETFs that track the S&P 500, but less than $30 million in products that track the Dow.

The third most closely watched index in America is the Nasdaq, which is different from the Dow or S&P in that it is an entire market rather than a selected basket of stocks. The Nasdaq was founded in 1971 as the world’s first all-electronic stock market, and quickly became a haven for smaller stocks that weren’t listed on the New York Stock Exchange. It still serves as a barometer for smaller, high-tech stocks. Keep in mind that stocks can be in both the Nasdaq index and in the Dow (such as Microsoft and Intel) or in the S&P 500.

One thing that the Dow Jones offers is blue-chip quality. While the S&P 500 provides a panoramic snapshot of the stock landscape, the Dow tells you how well the biggest and best companies are doing. Which one you want to pay more attention to depends totally on what you’re looking for.

 



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