Professionals may follow the more statistically accurate Standard & Poor 500 to measure the stock market but the general public still stands with the Dow Jones Industrial Average.
A railroad dominated Dow was created in 1884 but it soon gave way to an all Industrial Index of 12 stocks in 1896. The chart below shows the original and then the industrial Dow. You have to be quite the student to recognize any of the original names, save one – General Electric. Now even it is gone, replaced by Walgreens Boots Alliance, the drug store chain.
The 30 components of the Dow are decided by a group that includes the editors of the Wall Street Journal. Changes are not made often. Over the past ten years changes have occurred on only six occasions. A little known fact is that when a stock is taken out of the Dow it tends to outperform the stocks that are added. The last ten companies eliminated from the Dow have risen on average 6.4% in the year after their respective removals. By contrast the ten additions have fallen 4.6%.
What gives here? Well first, a stock that is eliminated has usually been a poor performer. The flipside of this however is that a falling stock price generally has a low valuation, meaning it is cheap. When the company does even slightly better than expectations, the stock price can increase quickly. Investors often drive stock prices to excessively low levels for behavioral reasons. We feel regret at having bought a loser and we want out no matter what the price. So we sell, which ironically creates a better bargain stock. So will GE now be one of these bargains? We wouldn’t be surprised.