The Dow needs a makeover

Is the Dow Jones industrial average in need of a makeover? Birinyi Associates believes that it is and acting now could save the index not only from suffering bigger losses but could also position it for a stronger rebound if and when that day comes.

“The answer to higher prices for the Dow Jones industrial average may not be a stimulus plan or less taxes but instead a change in its membership,” said Jeffrey Rubin, director of research at Birinyi Associates, in the first of a series of three notes on the subject.

Jettison the losers, he argued, and you might even send a healing hand to the stock market, since higher priced – and healthier – stocks will inspire excitement among investors rather than fears of writedowns, dividend cuts, bankruptcy and nationalization.

Shifting the Dow around is not without precedent. Indeed, its 30-stock membership is regularly tweaked. However, in 1932 – when stocks were still on the run following the crash of 1929 – it was given a full-scale makeover: Eight stocks were given the boot in favour of eight new stocks, including Coca-Cola Co., International Business Machines Corp. and Procter & Gamble.

The changes helped. According to Mr. Rubin, they limited subsequent stock market losses and gave the index a bigger boost when the recovery finally arrived. Had those changes not been made, the Dow would have bottomed out 29 per cent lower than its actual bottom. The index then bounced 136 per cent by July 1934, but would have risen just 92 per cent if the changes hadn't been made.

The problem with today's index, as with the 1930s version, is that too many stocks are languishing at multi-decade lows. Today, five stocks are trading below $10 (U.S.).

Since Dow stocks are weighted according to their price (a higher share price gives a stock a bigger influence on the index, regardless of the company's size), a rebound by some of the more beaten-up names won't move the index much. As of last Friday, the combined weight of the bottom five members was a mere 2.5 per cent. If they all doubled in price, the Dow would rise all of 184 points.

Mr. Rubin suggests ditching General Electric Co., Alcoa Inc., Bank of America Corp., Citigroup Inc. and General Motors Corp. – simply because it no longer matters how these stocks perform.

Among his suggested replacements: Baxter International Inc., Best Buy Co. Inc., Chubb Corp., General Mills Inc., Goldman Sachs Group Inc., Kimberly-Clark Corp., Monsanto Co., Newmont Mining Corp., Schlumberger Ltd. and Visa Inc.

Of course, you might wonder why the Dow matters at all. With just 30 stocks, it does not reflect the U.S. stock market as well as, say, the S&P 500. And although the Dow has underperformed the S&P 500 by nearly two percentage points this year, its longer term performance is very close to the broader index.

But Mr. Rubin points out that the Dow is still the index to watch. “When the New York Times or the Wall Street Journal or the Globe and Mail talks about a good day in the U.S. markets, do they quote the S&P 500 or do they say the ‘Dow rallies 236 points,?'” he said in an interview. “For individual investors it is still a very relevant index.”