Why The Dow's Revamp Could Propel It To New Highs

First, the Dow is not just important to our investment process, but it should be important to any investor with stock market exposure.

A lot of people own the Diamonds (industry lingo for $DIA) in their retirement account. If they don't own the Dow ETF outright, then they likely have a high degree of exposure to these massive blue-chip stocks through other funds they're invested in. The bottom line is, these are some of the largest companies in the world. If you are invested in any passive funds, you have exposure to them.

In fact, being added to the Dow is a catalyst in and of itself as the SPDR Dow Jones ETF provider, State Street (and others) creates demand when it needs to buy shares of the new stocks it adds to its $25B fund. Nothing illustrates this point better than a performance chart showing the returns of the six companies swapped in and out since the news was announced ahead of Monday's open.

Salesforce's returns were buoyed by a monster earnings beat this week, but the point remains. New additions have made nice moves higher while the names getting booted are more or less lower on the week.

So, what do these latest changes mean for the composition of the index itself? How much exposure to Tech will be left after the Apple split? How much Energy exposure is FINALLY removed by showing Exxon the exit? How will adding a leading Biotech firm for a lagging Pharma conglomerate impact the index's performance?

First, let's visualize the relative strength and performance of these stocks since the Dow's last pivot high in June. The bubble chart below includes ALL Dow Components, new and old, with the size of the bubble representing the stock price, or weighting. Remember, the Dow is a price-weighted index. The larger your stock price, the larger your representation is in the average.

Look at what a monster Apple has been for the Dow. Not only is it by far the largest holding, but the stock is up 150% over the trailing year and another 50% in just the past three months.

The Index hasn't been able to make new highs WITH Apple's massive weight driving its gains. How is it going to fare when Apple shrinks to about a quarter of its current weighting after its stock officially splits this coming Monday (August 31, 2020)? After all, Apple's move is what prompted the index provider to undergo this much-needed shakeup.

Apple's current weighting is over 12%. Its post-split weighting should be closer to the 3% ballpark. Apple has contributed almost 4x as much to the Dow's return as the next best-performing components over the trailing year*. Who's going to pick up for all its heavy lifting?

It appears the S&P Dow Jones Index Provider already thought this through pretty well.

[*You can check out cool stats like these about ETF holdings, as well as explore plenty more data at Koyfin.com.]

Based on some back of the napkin math, the new components will definitely have the size to do it as they should together make up over a 20% allocation.

What's more, is these new components are much stronger stocks, showing outperformance vs the broader market and trading at or near all-time highs. You can see this above, as they are all at the top of the chart, and to the right of the zero line on the x-axis. This represents that they are all near highs and have posted positive returns since June.

On the other hand, the components being removed only make up a lousy 3% of the index's holdings, and are serial underperformers, dragging on the index rather than help driving it higher. This is especially true for Exxon and Raytheon lately which have booked roughly 15 and 25% losses since June and are currently sitting at about 40% and 50% drawdowns, respectively.

The charts below will help illustrate why we think the Dow just got a nice facelift and should be better off with these recent changes despite losing some key weight from Apple.

Here's a secular laggard that just got the boot.

The stock is trading at its lowest level relative to the broader market in over 25 years. Later, Pfizer... you won't be missed.

How about Amgen, the component Pfizer is being replaced by?

Now, this is what we would call a secular leader - basically, the complete opposite of Pfizer, above.

Price continues to stair-step higher on an absolute basis while it works on breaking out of a 20-year base relative to the S&P 500. All-time highs on a relative and absolute basis. If this kind of leadership continues, we can count on Amgen to help drive the Dow higher in the future.

We actually like the setup in Amgen a lot right now. We recently outlined some trade ideas in the name for both Institutional and Premium Members, which you can read here.

Here's the most notorious Dow laggard, Exxon Mobil. As recently as 2013, Exxon was a leader. It was the largest U.S. company with a market value of over $415 billion. The times they are a-changin'... it just looks like someone forgot to let Exxon know.

As shown above, the stock has significantly underperformed the broader market over the past decade. As such, the company's market cap has shrunk to less than $180 billion as it looks headed down a familiar path of another former Dow leader, General Electric.

Now here's its replacement, Salesforce.com. JC already outlined the absolute setup in Salesforce in his post earlier this week, so let's continue to focus on relative strength.

This one speaks for itself. Salesforce is a secular leader in a very strong primary uptrend relative to the broader market. It just resolved higher from a multi-year base relative to the S&P and looks poised for some further outperformance.

The final two are a bit more tricky. Unlike Exxon and Pfizer, Raytheon (formerly, United Technologies $UTX) has been a steady outperformer relative to the broader market for most of its history. The same can be said for Honeywell. Although, over the trailing decade, Honeywell has significantly outperformed Raytheon.

Here's a performance chart, showing Honeywell more than quadrupling Raytheon's return over the trailing 10-years.

And here's a ratio chart of the two, dating back to 2007.

Bottom line, the Dow is much better off with an outperformer like Honeywell, than a laggard like Raytheon.

It should be pretty clear by now that the Dow Industrial Average just got a major upgrade by switching out a handful of underperformers for some of the market's top leaders. There are now fewer stocks in downtrends, which had been dragging on the index's performance, and more stocks in uptrends, which should help propel the index higher. For these reasons, we believe the new Dow will be a lot stronger than the old one.

Additionally, when considering the new components will immediately become some of the largest weightings, the recent reshuffle might even be the catalyst needed to finally drive the index to new record highs.

Now, wouldn't that be something?

Let us know if you think we have this right!

Allstarcharts Team