Booting GE Could Be Bad News for the Dow

The following is a reprint of the market commentary from the December 2017 edition of The Option Advisor, published on November 17. For more information, or to subscribe to The Option Advisor -- featuring 10 new option trades each month -- visit our online store.

By now, just about every major financial media outlet has published an article questioning how much longer General Electric (GE) can continue in its current, beaten-down state before it's unceremoniously booted from the Dow Jones Industrial Average (DJIA).The catalyst behind this headline trend is GE's spectacular share price implosion, which has broken an "unwritten rule" for Dow members -- specifically, that the share price of the most "expensive" component should ideally be no more than 10 times greater than the share price of the "cheapest" component.

And as of the close on Wednesday, Nov. 15, GE shares were priced at $18.26 -- the net result of a fairly staggering 42% year-to-date decline. By contrast, shares of Boeing (BA) ended the day at $262.86, up nearly 69% for 2017. In other words, BA shares were roughly 14 times more expensive than GE shares, representing an even wider share-price gulf than when the first of the aforementioned hand-wringing articles were penned.

GE has been a Dow component on and off since the index's conception in the late 1800s, and has been consistently "on" for the last 110 years. So while the stock's potential ouster from the Dow would certainly mark the end of an era, what would it mean for GE itself, and its (former) parent index? Previous studies run by our quantitative analysis team have shown that getting booted from the Nasdaq-100 Index (NDX) is a positive catalyst for most stocks, so we naturally wondered whether the same phenomenon might bode well for a "post-Dow" path forward for GE shares.

Below is the list of stocks that have been removed from the Dow since 1997. Since the March 2009 stock market bottom, these "blue-chip rejects" have done pretty well over the six-month and 12-month periods after their respective exits -- even Citigroup (C) and Bank of America (BAC), which took well-publicized drubbings in the aftermath of the financial crisis. And non-financial names have fared even better, led by a one-year return of nearly 90% for Arconic (ARNC), the former Alcoa.

Prior to that market bottom, however, stocks tended to struggle in their post-Dow performances. Witness Goodyear Tire & Rubber (GT), Honeywell (HON), and American International Group (AIG), all of which shed roughly half their value in the 12 months following their Dow dismissal.

To account for the kind of broad-market forces that likely contributed to this pre- and post-bottom dichotomy in returns, here's a look at how this group of 13 performed overall -- and, crucially, in relation to the Dow itself. The table below summarizes the returns for the 13 stocks above in the months and year immediately following their exit from the index, and includes a final row showing how many of these stocks were outpacing the broader Dow's returns over each time frame. As you can see, the Dow's most recent ex-component tends to lag the index's simultaneous returns; the percentage of individual stock returns exceeding those of the Dow falls as low as 23.1% over a three-month period -- and never rises higher than 38.5% (over a six-month stretch).

To put this in context, here are the returns for stocks that have been removed from the NDX and S&P 500 Index (SPX) in the last two decades. The equities that have left these two indexes have performed quite well in their post-benchmark endeavors, especially in comparison to the Dow departures. For example, NDX and SPX ex-components rack up average 12-month returns in the neighborhood of 25%, with approximately two-thirds of these returns positive. That compares quite favorably with the average 12-month return of 2.55% for stocks leaving the Dow, with just over half of the returns positive -- although, in fairness, all three indexes tend to outperform the majority of their "exes" over a 12-month time frame.

Drilling down on the Dow itself, here are the index's own returns following each of the aforementioned 13 departures. The Dow's median returns exceed those of its collective ex-components over every time frame, with the index's percentage of positive returns also considerably higher across the board.

That said, average returns for the Dow over the six-month and 12-month time frames lag those of its former members -- and note the stark difference in the Dow's average 12-month positive return (+9.94%) versus its average 12-month negative return (-22.93%).

But perhaps the most startling contrast is found in comparing the Dow's returns above, following the ouster of one of its components, against the table below displaying the same index's own "anytime" returns since 1997 over these various time frames. Certainly, the small sample size measured above is a worthy caveat, but it's safe to say that the performance of the "anytime" Dow is considerably more bullish, by several orders of magnitude, than the performance of the post-ouster Dow (note, in particular, the average one-year return of -0.18% above versus +6.53% below).

In the event that GE is removed from the Dow, we could reasonably expect to see deeper short-term losses for the stock, and longer-term underperformance relative to its former parent index. But perhaps the more pressing takeaway for investors would be the implications of GE's dismissal for the broader Dow, as previous such shake-ups to the index's composition have coincided with significantly lackluster returns for the broad-market measure.