The Not So Logical Reason Visa Is the Dow's Most Important Stock
The Dow Jones Industrial Average had risen 116 points by 1 p.m. EDT Wednesday, driven by broad-based buying across the index.
Leading the charge was Visa , which was up over 2% at the opening bell before retreating to a 1.7% gain by early afternoon. The stock's move higher came on a slow news morning for the company.
Visa won't report fiscal 2014 second-quarter earnings until April 24 after the bell. According to a survey by Zacks Investment Research, analysts expected Visa to report earnings of $2.18 per share for the quarter. That would be $0.02 lower than reported earnings per share for the quarter ended Dec. 31, 2013.
Visa traded down sharply in March, and the movement today is likely a bounce off of that sell-off. The credit card giant is one of the largest, most stable companies in the world. The fluctuation in its price over the past few weeks is tied to broader market movements instead of any real change in the company's fundamentals, as demonstrated by the anticipated stability in EPS noted above.
Why is the Dow so heavily influenced by Visa?
The Dow is a price-weighted average of its 30 component stocks. Visa is the most heavily weighted of those stocks.
Why Visa? Because on a per-share basis, Visa has the highest stock price of any Dow component. That's it. There's literally no other reason. This highlights a few shortcomings of the Dow.
Why the Dow is not the best proxy for the market
The first problem is the Dow's lack of diversity. It features only 30 companies, all of which are large-cap and U.S.-based. They are all somehow related to industry (it is the Dow Jones Industrial Average, after all).
Second, the price-weighted average calculation used to derive the Dow is a little arbitrary. Originally, the Dow consisted of 12 stocks back in 1896. At the end of each trading day, the prices for each stock would be added up and divided by the total number of companies in the index. And just like that, you had the Dow Jones Industrial Average.
Those 12 companies eventually expanded to 30 (only General Electric remains of the originals) and the calculation changed slightly to ensure a smooth historical graph. But the mechanics of the index are basically the same today as they were more than a century ago.
To understand just how significant Visa is to the Dow's overall movements, consider that Visa's 8.06% weight in the index is nearly equal to the 8.73% weight of these seven megacompanies, combined:
- Coca Cola
- General Electric
- Cisco Systems
Is Visa's stock movement really eight times more indicative of the broader market than Cisco? Or six times more critical to understanding the economy than Coca Cola? The answer to both questions is no.
For a real perspective of the broader market, the S&P 500 makes a lot more sense. It is much more diversified and is derived based on market cap instead of share price.
Why is the Dow the standard if it's so wonky?
There are a couple of reasons.
First, the Dow is really old and really well known. Your great-grandparents probably discussed the Dow over breakfast. Maybe even your great-great-grandparents. The Dow is, in fact, the oldest continuing U.S. market index.
Second, the U.S. market has been the center of the financial world for the past 100 years, and that clout transfers to U.S.-based indices. The names on the Dow component list are megacap companies; they're household names -- Coca Cola, Visa, and so on. These companies are extremely large, extremely popular, and extremely stable. Name recognition in the largest market in the world goes a long way.
The size and scale of these companies shouldn't be understated. They sell products and services to businesses and individuals all over the world. There are finance companies, conglomerates, manufacturers, and technology companies.
These are the companies that make the products we all buy and use every day. No, there aren't any social media darlings in the Dow, but why should there be? Selling ads isn't the same as building servers, constructing infrastructure, developing consumer goods, or making home loans.
So, in an indirect way, the Dow still serves its purpose pretty well. The 30 components combined have a market cap in excess of $4.8 trillion and cover just about every facet of U.S. business. It may be a bit illogical that Visa is weighted six times heavier than Coca-Cola, but the Dow nonetheless remains a solid representation of how big business in America is fairing in the markets 118 years after it was first calculated.
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The article The Not So Logical Reason Visa Is the Dow's Most Important Stock originally appeared on Fool.com.Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems, Coca-Cola, Intel, and Visa. The Motley Fool owns shares of Coca-Cola, General Electric Company, Intel, Microsoft, and Visa and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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