If a struggling company gets kicked off the Dow, then is the Dow meaningful?

(written by lawrence krubner, however indented passages are often quotes). You can contact lawrence at: lawrence@krubner.com, or follow me on Twitter.

General Electric is getting kicked off the Dow because of its financial struggles. But how meaningful is the Dow if it keeps getting rid of companies when they run into trouble? Some people point out that the Dow has mostly gone up over the last 120 years, and they see this as evidence of an expanding economy. But if they hide all the bad news, and only keep the good news, is the index really meaningful? If you only allow successful companies on the Dow, and you kick them out as soon as any have trouble, then obviously the Dow will tend to be going up. But that doesn’t reflect any kind of reality about the economy. It just means the Dow keeps adding successful companies to its index. While the real economy has grown over the last 100 years, the major stock indexes have all grown much more than the real economy. How is that possible, over 100 years? Partly it is because they play this game, where they get rid of a company when it is in trouble, and they bring in some other company that is doing well. If you only keep the winners on the indexes, the indexes will tend to report happier news than what would be justified if one only looked at the real economy.

From the article:

This isn’t GE’s first rejection letter. The company was removed from the Dow index in 1898, only to return seven months later. It was replaced again in 1901, but came back for good in 1907. This latest ouster is a sign of the company’s financial struggles, and of an ongoing shift (paywall) in which types of companies are still considered key indicators of the state of US industry.

“General Electric was an original member of the DJIA in 1896 and a member continuously since 1907,” David Blitzer, managing director of the S&P Dow Jones Indices committee, said in a statement (pdf). “Since then the U.S. economy has changed: Consumer, finance, health care and technology companies are more prominent today and the relative importance of industrial companies is less.”

Analysts have been speculating for months that GE might get the boot, with Deutsche Bank predicting in January that the company’s standing would be impacted by challenges around “earnings and cash pressure, tough global power generation markets, aggressive downsizing, shrinking its portfolio, management shake-up and SEC investigations.” Wrote Deutsche Bank analyst John Inch: “Apart from GE’s other challenges, as the company’s absolute share price has continued to drop, GE increasingly falls into the category of outlier and consequently a likely candidate for removal.”

Post external references

  1. 1