Friday, May 22, 2009

A detailed look at Dow: did GM bring it down today?

The headlines were screaming: Dow closes in the red today after GM's late-day skid. Perhaps a more appropriate headline should have read: A 25% decline in GM barely budges DOW. (After all, Dow was only down 0.18% today). The massive 25% decline in GM stock contributed only about 0.04% to Dow’s decline! (or about 25% of the day’s decline). So much for the adage, "as GM goes, so goes America".

The Dow is a price weighted index, so as the price of a stock goes to zero, the impact on the index becomes increasingly insignificant. The upshot is that GM’s contribution to Dow is basically non existent. If GM were to file for bankruptcy, and GM stock goes to 0, (or $0.01 as detailed in this SEC filing), the Dow would only be down by 0.1% because of it. That’s noise basically.

Just for fun, I decided to calculate the Dow Jones index with various components removed:

Dow index without different components

As can be seen, the impact of removing General Motors(GM) and Citigroup(C) from the Dow is only 0.5%. Looks like Mr. Market has basically priced in a GM bankruptcy and Citi common equity getting diluted to oblivion. Further, Bank of America(BAC) or General Electric(GE) going to zero would only result in declines of 1.06% and 1.26% respectively. Even including all four, we're looking at a 2.8% decline. So basically all these components becoming pretty much worthless is already priced in. What's NOT priced in however, is these components going back to their earlier price highs.

Wintel's effect on Dow: Just for fun, and for the sake of illustrating the weirdness caused by using price weighted indexes, I've included the impact on the Dow of removing Intel(INTC) and Microsoft(MSFT). As can be seen from the chart, both Intel and Microsoft can go out of business, and the Dow would only suffer a 3.3% decline.

Role of financials in Dow: Let’s assume that things become great and the financials go back to their pre-crash market capitalization. Even then, because of the record high equity dilution in the financials (because of TARP injections, preferred to common conversion, raising capital in the form of equity, etc) their stock prices would remain low (unless they do a reverse split). Because Dow is price weighted, what that basically implies is that the financials would have an increasingly small role to play in Dow’s daily gyrations, even assuming they go back to their previous market capitalization highs.

Financials under performing in the next bull market is almost a certainty as far as the Dow is concerned.

The data above basically shows how concentrated the Dow index really is. For all practical purposes, Dow is a 26-27 component index today.

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