What helped Dow Jones index now hurting it

NEW YORK -- It's the granddaddy of stock indexes, a centenarian that is sprightly for its age. Since a near fatal fall in March 2009, it's nearly doubled.

But the Dow Jones industrial average is starting to look frail.

The problem is that the blue-chip index has been relying heavily on just two of its 30 stocks, Caterpillar and IBM. Those companies were responsible for a fifth of the near-doubling in the index. But since it hit a 2012 high May 1, the Dow has slipped, and the software company and the heavy equipment maker have accounted for half of that decline.

"When you have a couple of very high-priced stocks, they're going to skew things," said Paul Hickey, co-founder of Bespoke Investment Group, a research firm. For Caterpillar especially, he adds, "economic strength" outside the U.S. has helped.

Now a lack of that same growth is punishing Caterpillar. China is growing at its slowest pace in three years. Other formerly booming markets, like Brazil, have slowed, too. Caterpillar, which makes mining, construction and farming equipment, generates about two-thirds of its revenue abroad.

Meanwhile, many metal and food prices are falling, compounding the company's woes. In the three years through March, the S&P GSCI, a commodity index, has doubled. Since then it's fallen 11 percent.

How much this will hurt the Peoria, Ill., company is unclear. But investors aren't waiting to find out. Their frenzied buying has turned into frenzied selling. The stock has fallen 20 percent since the Dow's recent peak in May.

IBM Corp., which makes much of its money in software and technology services, is also dropping on fears of slowing growth. It's down 7 percent.

Folks love to use the Dow as a shorthand for stocks, and for the economy as a whole. But for all its august appeal, the nation's oldest major index often reflects the movement of just a few stocks.

Ten years ago it was Procter & Gamble, the world's largest consumer products company. 3M, the post-it note maker, also held sway for a while.

The top-heavy nature of the Dow helps explain why it's lagging other indexes. So far this year, the Nasdaq composite of nearly 3,000 stocks is up 12 percent and the Standard & Poor's 500 is up 8 percent. But the Dow is only up 5 percent.

In the spring last year, the situation was reversed. The Dow was leading the S&P and the Nasdaq. Two big reasons? Caterpillar and IBM.

Two flaws

The Dow suffers from two flaws. The first is it's made up of just 30 stocks. The second is that the index treats a rise or fall of a single dollar in each of its 30 stocks the same whether or not that represents a big percentage change, and thus a big change in investor attitudes, or a small one. This means that higher-priced stocks can move the index up and down dramatically.

Take IBM, for example. Its stock has been hovering near $200. A fall of a $1 is a 0.5 percent drop. Now consider the same dollar drop for Bank of America, the lowest priced stock in the index. It trades a little above $7 per share. A $1 fall is a 14 percent drop.

Yet the Dow would fall by the same amount regardless.

The S&P 500 gets around this problem by assigning more weight to the move in a company's price the greater its market capitalization, or the total value of all of its shares. This creates its own distortions if a company rises in value fast. Still, Apple, the highest valued company in the world, represents 4 percent of the S&P, according to Howard Silverblatt, senior index analyst at S&P Indices. IBM's weighting in the Dow is 11 percent, according to S&P Dow Jones Indices.

The good news is that as IBM and Caterpillar fall, their percentage drops have less of impact on the index, and other companies start to hold more sway. The next big Dow components to watch are McDonald's and Chevron, both of which surpassed Caterpillar in price last year. Unfortunately, they face the same problems as Caterpillar does: slowing growth abroad and a drop in commodities prices.

McDonald's has fallen 5 percent since May. Chevron, which rises and falls with price of oil, is up nearly 2 percent.

Things may be looking up for IBM, the Dow's most expensive stock. On Thursday the company reported second-quarter earnings that beat analysts' estimates and raised its forecast for the year.

As for Caterpillar, the signs are more mixed. Wall Street analysts have been cutting their target prices for the stock. Another ominous sign: Yum Brands, the owner of Taco Bell and KFC among other restaurant chains, fell 1.4 percent Friday, to $64.95, a day after announcing slumping profits in China. Investors, after cheering big exposures to overseas markets, aren't so sure they like it now.

Keep your fingers crossed. On Wednesday, July 25, Caterpillar announces earnings. All else being equal, it could be a big day for Dow.