Kicking and screaming, the Dow Jones Industrial Average is slowly finding its way into the late 20th century, even as the 21st gets set to arrive. Today's announcement that, as of Monday, Union Carbide, Sears, Chevron, and Goodyear will be replaced by Home Depot, SBC Communications, Microsoft, and Intel (the latter two being the first Nasdaq stocks ever to appear in the Dow) is fine testimony to what all of us already knew: that the U.S. economy has changed dramatically in the last two decades, and that former industrial powerhouses have been superseded by the avatars of the New Economy.
Actually, the four new Dow companies are avatars of the old New Economy, since there's nary an Internet or telecom-equipment manufacturer among them. But when you consider that it took Dow Jones until 1997 to take Bethlehem Steel, a company whose industrial fortunes peaked sometime back in the 1930s, out of the index, getting Microsoft in there 13 years after it went public has to be seen as a minor success. Of course, Microsoft also has the largest market capitalization of any company in the world. So the Dow isn't exactly going out on a limb.
The striking thing about today's announcement is that changes in the Dow still make headlines, not because they happen so often (actually, they happen very rarely) but because the Dow is such an arbitrary collection of names to begin with. Any index is arbitrary in its inclusion and exclusion of names. But the Dow's size--it has just 30 companies--magnifies the effect of its arbitrariness. Looking to 30 companies to decipher the underlying health of the stock market, let alone of the U.S. economy as a whole, is senseless. Yet it remains true that for many, if not most, Americans, the stock market is the Dow.
That's had two contradictory consequences in recent years. On the one hand, it's led people to overestimate the nature of this bull market, especially in 1999. The average New York Stock Exchange stock, for instance, is now 30 percent off its 52-week high, while the S&P 500 is up just 5 percent for the year. The Dow, however, is up 12 percent for the year, and when it hit 11,000, pundits everywhere proclaimed--depending upon their bullishness and bearishness--this a milestone. In reality, it was a milestone only for this group of 30 stocks (and a changeable group at that). There are no broader conclusions to be drawn from their performance. And the same will be true if the Dow slips below 10,000.
The second consequence is that the focus on the Dow has led people to underestimate the performance of corporate America. There are a lot of terrific companies in the Dow. But if you just look at the four companies that will be leaving on Monday and the four companies that will be arriving, there is simply no comparison between them in terms of business fundamentals. The incoming companies have rapid growth in revenue and in cash flow, and extraordinarily high returns on invested capital. The outgoing companies have slow growth and low (in some cases, perhaps even negative) returns on invested capital. Was the Dow overvalued at 11,000? I don't know, but I'm sure it's a lot less likely to be overvalued with its new lineup in there.
This is not news to the stock market as a whole. The outgoing companies have an average market capitalization of $21 billion, while the incoming companies have an average market cap of $236 billion, even though the average revenues of the two groups are not that distinct. You could see this as yet more evidence that investors are too reckless. But it's better evidence that Dow Jones is only now realizing what the market as a whole has understood for most of this decade.