What the recent Dow shock could mean

This week, two new shares join the Dow Jones Industrial Average, Nvidia Inc (NASDAQ:NVDA) And Sherwin Williams Co (NYSE:SHW). The Dow is a widely used index consisting of the 30 largest companies with a history dating back to the 19th century. NVDA and SHW will replace Intel (INTC) and Dow Inc. (DOW) – unrelated to the index. This week I examine past changes in the Dow's constituents and examine how stocks tended to perform after they were added or removed.

I have a list of 26 stocks that have been included in the Dow Industrials since 1997. I looked at how these stocks performed after they were officially added to the index. The table below summarizes the returns. The second table is for comparison and shows what the return would have been if you had bought the index and not the individual stocks.

The results are mixed. The stocks returned an average of 8% in the first three months of inclusion in the index, with 65% of returns being positive. However, a year after the additions, those same stocks were up just 1.74% on average, with less than half of the returns positive. Therefore, avoid NVDA and SHW and put the money in a Dow index fund. Buying the Dow index instead of stocks would have returned an average of 7.45%, with 84% of returns being positive over the next year.

The Dow's last change occurred in early February, when Amazon.com Inc (NASDAQ:AMZN) replaced Walgreens Boots Alliance Inc (NASDAQ:WBA). Since then, AMZN has gained over 12% while WBA has fallen more than 50%. The table below shows the stocks that have been added to the Dow since 2010. These stocks performed better than the table summarized above, but still less than half outperformed the index over the next six months and next year.

My list of stocks removed from the Dow is smaller than the stocks added because more of these companies have gone out of business or been acquired. So maybe we're not getting the full picture. The 18 stocks for which I have data performed horribly, especially immediately after exiting the index. These stocks posted an average loss of over 8% in the next trading month after leaving the index, with only 17% being positive or outperforming the Dow index. Six-month returns also fell well short of expectations, recording an average loss of 2.7%, with 33% positive. However, nine of the 18 stocks beat the Dow over the next six months.

Here is the list of individual stocks that have been removed from the index since 2010. These ten stocks significantly underperformed in the first month of trading, posting an average loss of 3.8%, with only 30% positive and 30% outperforming the Dow index. In the longer term, the stocks removed from the index have performed significantly better than newly added stocks. Over the next year, these stocks averaged an impressive 28% return, with 67% of them outperforming the index. Stocks added to the Dow since 2010 have returned an average of 6.3%, with only 44% outperforming the Dow index (see table above).

The story continues

One way to look at index changes, especially with such a popular index, is to view them as a driver or indicator of sentiment. Stocks included in the blue chip index could provide positive sentiment, while those removed could cause some people's stocks to disappear. I could argue that the data above supports this interpretation. New stocks in the index performed worse and were less likely to outperform the index than those excluded from the index. I'm focusing on the data since 2010. Based on the analysis, maybe wait at least a month and then take a look at the two recently eliminated stocks, INTC and SHW.