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The Dow's Flaws Uncovered

Last month, the much celebrated Dow Jones Industrial Average (^DJI) replaced Alcoa, Bank of America, and Hewlett Packard with Nike, Goldman Sachs, and Visa. Although the Dow Jones Index Committee sold the changes as an improvement, the Dow's adjustments were purely cosmetic and now put the benchmark at risk of a higher level of volatility, as we're already seeing.

Today, Goldman Sachs ( GS ) slid around 2.6% after reporting a year-over-year revenue decline and IBM ( IBM ) fell 6.5% after it missed third quarter revenue estimates. Both stocks are the second and third highest weighted companies within the Dow Industrials. Why does it matter?

Unlike the S&P 500 (NYSEARCA:SPY), a market cap weighted index, the Dow weights companies by their share price. (Also, see Is the New Look Dow an Upgrade or Downgrade?) In other words, stocks with the highest share price have the greatest influence on the Dow's performance. Not only is this a badly outdated way to construct an equity benchmark, but it's a serious flaw.

In the October ETF Profit Strategy Newsletter, we wrote:

"In what likely will turn out to be an obvious case of returns chasing, an additional sign of a market topping, as well as another situation where calculations and formulas are manipulated for a purpose of covering up fundamentals, the Dow Committee is trying to piggyback off of the continued price gains in Goldman Sachs, Visa, and to a lesser degree Nike. Extra return does not come without increased risks, and the committee has also now set the Dow up for significantly more downside risk. With euphoria running sky high, no doubt the committee ignored this potential downside risk in order to gamble on a continued run in the prices of Visa, Goldman, and Nike, and that makes the Dow now even more vulnerable to a significant market decline, unintended or not."

Figure 4 below illustrates the mathematical impact of a hypothetical 40% decline in the three newest Dow components. This hypothetical decline, it should be noted, is similar in magnitude to the 2008-09 crash. And as our table illustrates, the three newest Dow components would take down the Dow by approximately 7.1% in a bear market environment. That compares with just a 0.9% decline in the Dow, assuming the same 40% magnitude fall in the previous Dow companies - Alcoa, Bank of America, and Hewlett Packard.

By holding just 30 stocks, the Dow Industrials (NYSEARCA:DIA) also lacks the sector diversification or depth of even broader stock benchmarks like the Russell 1000 (NYSEARCA:IWB) or Dow Jones U.S. Broad Market Index (NYSEARCA:SCHB). Translation: The Dow Industrials, along with its tracking ETF, is a poor choice for investors that want a core or long-term holding to the U.S. stock market.

T ime and price will tell us if this benchmark shuffle turns out to be one of the worst timed Dow moves in history. Thus far, it's not looking good.

The ETF Profit Strategy Newsletter uses a combination of market sentiment, fundamental/technical analysis, market history, and common sense to be on the right side of the market. Since the beginning of the year, 74% of our time stamped ETF picks have turned a profit and our biggest win was a +525% gainer. (through 9/30/13)

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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