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Are the changes to the Dow Jones working out?

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It is not hard to notice that the Dow Jones Industrial Average would have finished Friday’s session with a gain had the changes to the index not been made after the market close on Sept 19, 2013. Friday’s index loss was largely due to a $4.06 (5.12%) plunge in new component Nike (NKE), but aided by the drop in newcomer Goldman Sacs (GS) down $2.27 (1.34%) and partially offset by an increase in the new addition Visa (V) as it finished higher, up $1.55 (0.70%).

The Dow Jones is evenly weighted. In other words if you bought 1 share (or any other equal number of shares) of each of the components, your percentage of gains or losses would be the same as that seen on the index.

The weighting of the index comes in due to changes to the index. For instance when Alcoa (AA), Bank of America (BAC) and Hewlett Packard (HPQ) were deleted, they took the total value of the index at the time of the change and split it for an even number of shares of each of the included components at their current price at the time of the change. Each change to the index changes the share balance of all the components.

The total of the closing price of one share of each of the components of the DJIA on Friday was $2538.60 and the total of gains and losses on that one share of each component amounted to a loss of $4.40, providing a 0.17% loss, exactly the same as the index saw. Subtracting the loss of $4.78 in Friday’s finishes of the additions from the $4.40 drop seen on all the components puts the Dow at a close of $0.38 higher instead of lower.

Those that were replaced in the index included Alcoa (AA) with a gain Friday of $0.10 (0.84%), Hewlett Packard (HPQ) with a gain of $0.47 (1.49%) and Bank of America (BAC) that dropped 2.01%, but it only lost $0.36 in the fall. Reinstalling the deletions would result in an additional increase of $0.11 in equal weighting. Adding the deletions increase to the gain without the new components gave the Dow a gain of $0.49 or 0.01% higher for the session instead of a 0.17% loss.

Since the share weighting changed when the additions were made, these numbers can’t be plugged directly in to give an index value as each of the remaining components gave up share base to allow the higher priced stocks into the index. The problem with this is many that gave up share base to allow the high priced newcomers in, are doing much better than the newcomers. Since the old components provided a gain, the reduced weighting on these components further reduced the Dow’s overall price.

Without the change the Dow Jones would not have finished Friday at a record high, but would have been much closer to this record than it is. It probably would have set an intraday high before finishing lower though. It is also likely it would have reached a record high close just prior to the most recent pullback.

Although all three of the additions are up since they entered the index, all three have hindered the Dow since it reached a record high on Dec 31. All three of those that were deleted are higher in both timeframes; in fact all three of the deletions have outperformed the new additions quite soundly on a percentage basis in both timeframes.

The additions: Goldman Sacs is up 0.42% since entering the index, but down 5.82% ($10.31) since Dec 31. Visa is up 18.45% since joining the index, but up only 0.31% ($0.69) since Dec 31. Nike is up 19.02% since joining the index, but down 4.36% ($3.43) since Dec 31. The newcomer’s total losses are $13.05 since Dec. 31.

Those replaced: Bank of America (BAC) is up 19.05% since being replaced and is 12.78% ($1.99) higher since Dec 31. Hewlett Packard (HPQ) is up 25.25% since being replaced and 13.82% ($3.97) higher since Dec 31. Alcoa (AA) is up 46.54% since being replaced and 12.98% ($1.38) higher than it was Dec 31. That gives the deletions a $7.34 increase.

Those that pressured Standard and Poors to make these changes got what they wanted; higher priced stocks in the index that can push the index value up faster, but these higher priced stocks can also push the index value down faster too. The changes probably haven’t work out like they thought, as since Dec 31, the higher priced additions are pushing the index down and preventing it from reaching new all-time highs.

There is a reason that many invest in “The Dogs of the Dow”, especially when there are good reasons for them to rebound, they tend to outperform the high fliers. It looks like dumping the dogs from the index probably wasn’t a good idea.

But these high fliers present other problems, if these three additions don’t split and bring their share price down, their volume will begin to slip and their price rise will soften. Extensive and ongoing research into stocks that don’t split shows volumes nearly always fall off and that stock price increases slow as prices increase too.

This phenomenon is independent of earning increases; low priced stocks with lower earnings increases often outperform the high priced stock peers. This research certainly makes it appear that the stock price is the element of the equation that causes the slowdown.

This research has led to this conclusion:

It’s simple mathematics. The first problem is average Joe doesn’t buy very many stocks over $100 and if he does they are small share amounts, so a lot of potential buyers are lost once the price exceeds $100. It appears that average Joe tends to shed these winners at the higher prices and does not reinvest later either.

The next problem is a very large purchaser of stocks is Mutual Funds; they generally invest a percentage of inflow into stocks they are investing in. If they still consider the higher priced stock a buy once it reaches this higher price; with the same inflow of funds they had when the stock was priced at $50 they are buying half as many shares at $100.

So average Joe isn’t buying as much, some Joes are selling and at the same time Mutual Funds are taking fewer and fewer shares as the price increases. As a result volume shrinks. The data also makes it look like that somewhere between $300 to $1000 even wealthier investors might begin to look elsewhere regardless of earnings potential, further pressuring volumes.

As volume shrinks supply and demand kicks in. Supply usually hasn’t changed much even with stock buybacks due to the higher price restricting the number of shares that can be repurchased. But demand is falling, with the lower demand the stock price simply doesn’t move higher as fast anymore. All stocks that don’t split encounter it eventually; the only variable is that some might fly higher before it kicks in than others.

Even Berkshire Hathaway (BRK-A) has seen the softening of price increases into a higher priced stock. Had they not split, the Class A share price would have continued to flounder, probably seeing less than half of the value growth it had seen with the splits.

Yes, I know Berkshire Hathaway Class A shares have never split, but Berkshire Hathaway did split twice by issuing Class B (BRK-B) shares at a fraction of the Class A share prices. The initial split was 30 for 1 and the latter split the Class B shares again at 50 for 1. The splits allows Class A shareholders to exchange their shares for a split ratio of the Class B shares, currently 1500 for 1, but it does not allow the exchange back into Class A shares from Class B shares.

The solution to break price stagnation in Berkshire shares was to bring average Joe back into the picture. Average Joe wasn’t buying shares at tens to hundreds of thousands of dollars each, but average Joe did buy the split shares.

The splits also renewed buying by funds. The last split allowed Berkshire’s inclusion in the S&P 500, and that alone promoted several billion dollars in share sales as mutual funds that mimic the S&P 500 needed to buy the weighted portion of these shares with their inclusion into the index. Since Berkshire is weighted heavily in the S&P 500 and there are hundreds of funds that try to mimic the index by buying shares in the constituents weighted according to the index, the share purchases with the inclusion in the S&P 500 could have perhaps reached hundreds of billions.

With each of the two splits the price of Class A shares had a renewed push higher, at well over double the rate of price appreciation it had been prior to the split in each case. For instance from Jan 1990 until the first split in May of 1996, Class A shares increased in value by $26,800 in almost six and a half years. Two years after the split they had increased in value by $32,000, the percentage of increase was smaller during the two years, but the value added was far greater. The price stagnated again not long after though, increasing only $38,850 more in the nearly 12 years leading into the second split in Jan 2010. In the little over four years since that split the share price of Class A shares have increased by $70,850.

The splits in essence gave Class A shareholders the chance to sell their shares, which was difficult to do without average Joe. They were very few buyers that could afford Class A shares and most that could afford them and wanted them had already bought. Funds that were still buying them weren’t taking large portions of these shares due to the high price. Before the splits volume plummeted and share price growth had stagnated, even though Berkshire was increasing earnings faster than many with lower share prices, their share price was not growing as fast as many of the lower priced stocks.

In the first year after the first split the share price was greatly affected by those that were taking profits, but once these sellers abated, the share price nearly doubled in twelve months.

Berkshire gives a very interesting perspective to splits since it used two classes of shares to provide these splits and allows direct correlation between the splits and the effects it had on the shares that were not split. The share price increases illustrated by Berkshire are commonly seen in share prices that split all classes of shares. The stagnation without splits also reflects that seen in stocks that don’t split and reach high stock prices.

With the Dow Jones stacked with higher priced stocks, it could be detrimental to the index in a downturn. Downturns in the newcomers and other higher priced stocks within the index helped to pull the Dow Jones lower than the other indexes in recent downturns.

As can be seen in the weekly "Stock Market Previews" the Dow has shown one of the most bearish charts in downturns since the changes to the index were made, but this was not very often the case before the changes. Many times it held the most bullish chart in downturns and in rebounds afterwards. This sudden change was likely due to throwing the normal balance of the index off with too many high priced stocks.

The Dow is also the only index of the five covered in the Previews that has not pushed to a new high this year.

The recent changes to the index might have influenced others in the index to forgo splits fearing the lower price could spur their being replaced. There are several that have historically split at or even below their current prices but currently have no plans to do so. If this continues to be the case the absence of splits will eventually slow price growth in these stocks and the index overall.

Most stocks eventually split, or fold over and fall back to a lower price. These fold overs are often devastating falls in comparison to lower priced stocks when looking at them on an equal weight basis.

Crash data shows the greatest dollar losses are almost always produced in the highest priced stocks’ falls. A 50% fall on a $30 share produces a $15 loss while a 50% fall from $200 stock produces a $100 loss. Even if the higher priced stock were to fall at a smaller percentage; a 30% fall in a $100 stock would produce double the price loss at $30, than the $15 lost in a 50% tumble in the $30 stock.

The problem is often seen in higher priced stocks even without a crash. Since their higher price has excluded average Joe, there are fewer investors overall. The investors that are left are generally more in tune to the daily news and react to it very quickly.

With fewer investors, fewer jumping ship can cause big losses and the big losses can cause more to jump ship. The same news that could cause a $30 stock to fall 5% or less could cause a stock priced above $100 stock to shed 8% or more. The recent Biotech news that caused a selloff in these stocks illustrates this, but it has surfaced many times before.

Many of these sources of information were used in this article.

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Have a great day trading,
ronz

Access to all of Ron’s past articles.

Disclosure: Ron has investments in AA, BAC and HPQ. Ron has no investments in GS, NKE, V, BRK-A or BRK-B. Due to his research, Ron often divests stocks that don’t split after reaching high prices and seldom purchases stocks over $100. Ron is currently about 87% invested long in stocks in his trading accounts.

Disclaimer: This article is intended to provoke thought about investment possibilities. Acting on the information provided is at your own risk. You are urged to do your own research, and where appropriate, seek professional investment advice before acting on any information contained in these articles.

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