Conglomerate General Electric(NYSE:GE) took a big hit Friday after reporting net income that was down 6% year over year and earnings from continuing operations bombing 8% in the first quarter. The news was downright dismal, and at last glance, GE was down 13% on the day, and yet the Dow Jones Industrial Average (DJIA) had only fallen 2.14%.
GE is one of only 30 total stocks that make up the Dow. With today's icky news from GE, one would think the Dow would be down a lot more. But it's not. The truth is that GE's news barely affects the Dow. Let's explore why.
Calculating the Dow
First, it's important to understand that the DJIA is price-weighted, not market-cap weighted, like the Nasdaq Composite, or S&P 500. As Dow Jones puts it, "Their [DJ Indexes] component weightings are therefore affected only by changes in the stocks' prices, in contrast with other indexes' weightings that are affected by both price changes and changes in the number of shares outstanding."
Intuitive thought would conclude the Dow is calculated by adding up all of the prices within the index and then dividing by 30. But that's wrong.
Calculating the Dow (as of the close of April 10), using the aforementioned would look like this:
All 30 Prices Added = 1,545.32
Divided by 30 = 51.51
Clearly, the simple "average" is not what we see on a daily basis. Here's why: The boys and girls over at Dow Jones figured out that if you have an index of 100 stocks and each is trading at $100 a share, the index average would be $100. However, if you have 100 stocks and each is trading at $100 and one splits, you would then have a total of $950. And $950 divided by 10 = 95. Thus, the split caused a 5% decline in the index when it shouldn't have. (To learn more, read Understanding Stock Splits.)
To solve the problem, Dow Jones figured out that if you use a "divisor", the split issue is solved. The divisor is the total number less, the adjusted down split value. In other words, in the above example, by dividing the index total of $950 by 9.5 (notice 0.50 is removed for the split), the total is 100.
Over the years, Dow Jones has been slowly lowering the divisor to account for every split within the index. The Dow divisor is now: 0.122834016. So that's how the Dow Jones Industrial Average is calculated. At any given moment all of the prices are added up and divided by 0.122834016. But there's even more to the story.
Price Weighting Built for Bullishness
I swear, those people over at Dow Jones are really, really savvy. If they were to market-cap weight their index, instead of price-cap, the historical performance of the Dow Jones Industrial Average wouldn't be what it is. In the present 13-year ascending trend, the Dow is up about 700%, which sounds pretty good, doesn't it?
When you price-weight an index, the stocks that are more expensive absolutely have more pull on the larger value. If you have a $100 dollar stock and a $20 stock, the $100 stock is going to have five times the pull within the index over the $20 stock. That's why the Dow is naturally built for bullishness.
As stocks gain in value, they naturally add more top end weight to the index and pull it up. On the other hand, when one, or two of the most expensive stocks fall out of bed, they drag the Dow down quickly. That brings us back to our current example.
The top five stocks IBM (NYSE:IBM), ChevronTexaco (NYSE:CVX), Exxon Mobile (NYSE:XOM), 3M (NYSE:MMM) and Boeing (NYSE:BA) account for about 28% of the Dow's total weighting as of April 10. And as of April 10, GE was No.21 on the list, with only 2.38% weight. Now that it's fallen 13% during Friday's session, it will probably be No.26 on the list, with weighting of 2%, or less.
So what you need to know is this: If the top stocks in the Dow begin to tumble, look out. When "lesser" stocks like GE report dismal earnings, and the top stocks hold ground, so will the Dow.
For continued reading on this subject, see our article Calculating The Dow Jones Industrial Average.