Making Sense of the Big Changes to the Dow Jones Index

In the biggest Dow Index changes in nearly a decade, Alcoa Inc. (NYSE: AA), Hewlett-Packard Co. (NYSE: HPQ), and Bank of America Corp (NYSE: BAC) are being dumped from the closely watched 30-stock index.

Athletic gear maker Nike Inc. (NYSE: NKE) steps into the place of Alcoa, a Dow component for 54 years. Payments company Visa Inc. (NYSE: V) will unseat HP, which joined the blue-chip benchmark in 1997. And Goldman Sachs Group Inc. (NYSE: GS) replaces BofA, which joined the index five years ago.

The Dow changes take effect with the close of trading on Sept. 20.

The last time a Dow shake-up caused such a stir was in April 2004, when AT&T (NYSE: T), Eastman Kodak (currently in bankruptcy proceedings), and International Paper Co. (NYSE: IP) were removed and replaced with American International Group Inc. (NYSE: AIG), Pfizer Inc. (NYSE: PFE), and Verizon Communications Inc. (NYSE: VZ). 

Created in 1897, the Dow has undergone a number of changes since its inception. General Electric Co. (NYSE: GE) is the sole surviving original member.

The Dow is up roughly 15% year to date - with no help from the three companies that were just shown the door...

Why Companies Get Removed from the Dow

According to a statement from S&P Dow Jones Indices LLC, the company that oversees the Dow, the changes "were prompted by the low stock price of the three companies slated for removal and the Index Committee's desire to diversify the sector and industry group representations of the index."

Unlike other indexes, which are weighted by members' market cap, the Dow is a price-weighted index. That means the greater the stock price, the greater the sway for a particular component (and thus the index) and vice versa.

So, the index aims not to keep too many low or very high priced stocks among its members. Given that explanation, Alcoa, BofA, and HP's dismissals appear warranted. 

Alcoa, trading around $8.08, is down from $40 in 2007. Its elimination is especially symbolic. The aluminum company joined the Dow in 1959. For decades, its quarterly financial reports traditionally kicked off earnings season.

HP, at $22.36, is less than half the $50 it was trading at in 2010. An attempt at a turnaround, overshadowed by the revolving door in its chief executive officer's office, has been slow going.  When added to the Dow in 1997, it was only the second computer company in the Dow (after IBM).

Bank of America, at $14.48, is down from $50 in 2007. It became a Dow member in November 2008. Since the financial crisis, BofA has been plagued with lawsuits stemming from its mortgage dealings, and it has been trimming business units.

The Dow newbies, each industry standouts, also reflect a changing economic landscape...

Visa shares have been on a tear, and the company is growing on the strength of new payment technology. Nike continues to grow revenue and shareholder value thanks to a loyal worldwide following. And Goldman recently reported that earnings doubled in the latest quarter.

The Dow changes are likely to bring greater movement in the benchmark when the new components are seeded. The three heavyweights, known to make big moves up and down, are replacing a much less volatile trio.

But there's good news in these Dow changes for those investing in these rejected stocks...

Dow Changes and Share Prices

While getting booted from the Dow might be an ego bruiser, it just might turn out to be fruitful misfortune.

According to an in-depth study by renowned finance professor Jeremy Siegel of the esteemed Wharton University, stocks that were kicked out of the broad-based S&P 500 Index, on average, outperformed the additions. Siegel's research measured all additions and deletion going back to the S&P's creation in March 1957.

The findings could be easily explained as follows: companies shown the exit are often suffering financially, while replacements are typically leaders in their respective fields.

 MarketWatch likened the Dow's historical rotation to the amateurish trading faux pas of "buying high and selling low."

Following news of the Dow's upcoming dance, shares of Alcoa and HP were unchanged, while BofA shares were up 1.14%. Meanwhile, Goldman gained 3.3%, Visa soared 3%, and Nike sprinted ahead 1.53%.

Now don't miss today's main Money Morning story: How a 1% Gain Can Destroy Your Retirement Dreams (Part I)

Related Articles:

MarketWatch:
Getting Booted from Dow a Blessing Forbes:
Goldman, Visa and Nike to Join the Dow-Replacing BofA, H-P and Alcoa The New York Times:
Dow Index Drops Bank of America, Alcoa and H.P.