Why you can count on the Dow making changes in February

By Tomi Kilgore

Walmart's stock split gives the keepers of the 30-component index a good reason to boot some companies and add others

Investors can count on the Dow Jones Industrial Average changing its members in the coming weeks, for the first time in nearly four years, for several reasons. The question is, who's out and who's in?

How and when the keepers of the Dow DJIA choose the stocks they add and those they boot from the 128-year-old index has always been a closely guarded secret.

But there are a number of reasons - including the index's current makeup and relative performance - to believe a reshuffling will take place around the end of February.

'Selecting a company for any index is part art and part science. With the Dow, it becomes a lot more art.'Howard Silverblatt, senior index analyst at S&P Dow Jones Indices

The last time the Dow made a change was in August 2020, when Salesforce Inc. (CRM), Amgen Inc. (AMGN) and Honeywell International Inc. (HON) were added, and Exxon Mobil Corp. (XOM), Pfizer Inc. (PFE) and RTX Corp. (RTX), the former Raytheon, were kicked out.

S&P Dow Jones Indices said that that change was prompted by Apple Inc.'s (AAPL) decision to implement a 4-for-1 stock split. A much lower price for Apple's stock reduced the technology sector's weighting in the Dow, so the keepers chose to add Salesforce, a software company.

The reason a lower stock price matters is that the Dow is a price-weighted index, which means stocks with higher prices have more influence than lower-priced stocks on the index's overall price. In contrast, the S&P 500 index SPX is market-capitalization weighted, meaning the effect a company's stock has on the index is based on that company's market value.

Read: Here's why the Dow's drop is mostly Boeing's fault

Apple's stock split also gave the Dow keepers a reason to make other changes, removing "overlap" and adding new types of businesses that better reflect the U.S. economy.

The timing is right for more changes

For the first time since Apple's move, another Dow component is implementing a stock split.

Walmart Inc. (WMT) said late Wednesday that a 3-for-1 stock split will take effect when the market opens on Feb. 26. Based on current prices, lowering the retail giant's stock price by one-third would reduce its ranking in the Dow to 26th from 17th.

Read more about what stock splits mean for a company.

As of the end of 2023, the consumer staples sector, of which Walmart is a member, had a 6.8% weighting in the Dow, compared with a 6.2% weighting in the S&P 500.

At the very least, the "divisor," or the number used to calculate what effect a Dow component's stock-price change has on the Dow's price, will have to change after Walmart's stock split. There are reasons to believe other Dow changes are coming, and the split gives the Dow's keepers a good reason to announce them this month.

Picking Dow stocks is not a science

"Selecting a company for any index is part art and part science," Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, told MarketWatch. "With the Dow, it becomes a lot more art."

There are only a couple of hard rules for which companies can be included in the Dow.

"You have to be in the S&P 500" to be considered for the Dow, Silverblatt said, which means the companies have to be domiciled in the U.S. and meet other market-capitalization and trading-liquidity standards.

And the companies can't be part of the transportation or utilities sectors, because those sectors are tracked by the Dow Jones Transportation Average DJT and the Dow Jones Utility Average DJU.

There are also some unwritten rules that have evolved over the years.

At one point, the Dow keepers had preferred that the ratio of the highest stock price to the lowest stock price of its members be less than 10 to 1. Currently, the price of UnitedHealth Group Inc.'s stock (UNH) is about 22 times the price of Walgreens Boots Alliance Inc. shares (WBA).

There was also a time when companies that didn't pay a dividend weren't considered, but Boeing Co. (BA) and Salesforce currently don't pay dividends.

And at one point, companies with multiple classes of stocks, such as Google parent Alphabet Inc. (GOOGL) (GOOG) and Warren Buffett's Berkshire Hathaway Inc. (BRK.B) (BRK.A), weren't included, but the number of classes isn't something that is currently considered, Silverblatt said.

What's preferred may have evolved, but the goal hasn't. The Dow represents high-end or "blue chip" companies - and the American economy, Silverblatt said.

Dow's correlation with the S&P 500 is the lowest in years

One criticism of the Dow has been that 30 stocks that don't include transportation or utility companies can't represent the entire U.S. economy and stock market.

Over the long term, the Dow keepers have been exceptional at stock picking. The correlation coefficient between the Dow and the S&P 500 over the past 30 years has been 0.99, where a reading of 1.00 means they moved perfectly in tandem.

Read more about how the Dow could be viewed as "the best active fund ever fashioned."

But the correlation has been at its lowest level in years as the technology sector, led by the companies known as the Magnificent Seven, has grown in prominence in other stock-market measures. As of Dec. 29, the information technology sector had a 28.9% weighting in the S&P 500 but only a 19.2% weighting in the Dow.

The correlation coefficient between the indexes was 0.87 in 2023 and 0.89 in 2022. Through January 2024, it was 0.90, with the indexes closing in opposite directions in eight of the month's 21 trading sessions.

The last time the correlation was below 0.90 for two consecutive years was in 2004 (0.84) and 2005 (0.77).

Again, the Dow keepers are in it for the long term. But as Silverblatt said, the selection criteria has changed over the years because the stock market and the economy are constantly evolving.

That's why, although the Dow keepers typically meet weekly or monthly, they monitor the markets and have conversations every day, Silverblatt said.

The last time they waited more than three years to make changes was from June 2009 to September 2012, in the wake of the financial crisis.

When it comes to which sector weightings may need adjusting, it's worth noting that the financial sector is the Dow's highest, weighted at 20.9% but it carries only a 13% weighting in the S&P 500.

Currently, four of the Dow's 30 members are from the financial sector: Visa Inc. (V), JPMorgan Chase & Co. (JPM), Goldman Sachs Group Inc. (GS) and American Express Co. (AXP).

Meanwhile, the communications services sector, which includes two of the Magnificent Seven - Alphabet and Meta Platforms Inc. (META) - has a 2.2% weighting in the Dow but an 8.6% weighting in the S&P 500.

-Tomi Kilgore

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02-03-24 0648ET

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