General Electric (Ticker: GE) was removed from the Dow Jones Industrial Average this week, marking the last of the original 12 stocks that made up the index in 1896, and will be replaced by Walgreens. GE finds itself down more than 25% year-to-date at the time of this writing. Frankly, the once giant of industry pioneered by Thomas Edison and famously managed by Jack Welch has struggled. Jeffery Immelt, the previous CEO, was relieved of command (retired) in October of 2017.
There will be arguments as to whether GE’s financial struggles were the cause for the removal or whether the leaders of the index were more interested in moving toward healthcare. There is another issue in the mix however and it is simply business. The indices selection committee naturally wants their levels to go up.
The famous S&P 500 is a market capital weighted index as are most other indices in the marketplace. As a reminder, market capitalization is calculated by taking the current share price of a company’s stock multiplied by the number of shares currently outstanding. For example, GE has a market cap of roughly $112 billion compared to Microsoft’s $775 billion. Microsoft’s percentage moves are very important for the S&P 500 calculations because of the massive market capitalization not the share price. At the end of 2017, the five largest companies by market capitalization represented 12% of the value of the entire index. The use of market capitalization is true of almost all indices that are tracked with the Dow being a notable exception.
The Dow is price-weighted. The number of shares a company has outstanding has nothing to do with its weighting within the index. It is merely the change of the value of the shares. Thus, the stocks with the highest price have a largest market share of the Dow index than necessarily the largest company.
Microsoft is one of the 30 Dow components and trades near $100 per share. A one percent move is $1 and the Dow and S&P 500 would change accordingly. (The math for the Dow is calculated going all the way back to 1896 so that when changes are made – there have been 51over the years – the index is properly calculated.) GE is near $13 per share. That means if GE increased by one percent the stock price would only have to increase by $0.13 having very little impact on the overall index. GE would have to have an increase of almost 8% to equal the move of Microsoft in the price-weighted Dow.
There are those that argue the difference between price-weighting compared to market capitalization yields similar results. Perhaps, but it is a major difference for the indices trying (in our opinion) to achieve ever higher levels.
Understanding market capitalization is critical when you discuss moves in the markets. The top four sectors of the S&P 500 control almost 66% of the entire value with technology leading the way at 26% of the large-cap index. The GE story is major and sad at the same time but making sure you understand what you own matters more to your financial future.
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