useful market gauge, or just a headline number

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The Dow: Useful Market Gauge, or Just a Headline Number ?

Mario Ferro | August 18, 2010

The index of 30 Dow Jones Industrial stocks, often referred to simply as the Dow, has been around in some form or other

for over 100 years. But as it is no longer entirely made up of industrial issues and not actually an average, is it stillrelevant? Exactly what purpose does it serve? Does it really represent a snapshot of the market? Is it a useful benchmarkagainst which to measure performance? Is it fairly weighted? Do historical comparisons mean anything? How can theindividual investor use it? How does it compare with other indexes?

Dow, Meets Jones

The first Industrial Average, compiled by journalist Charles H. Dow, along with his associate Edward Jones debuted in1896, and was made up of 12 stocks. The figure was arrived at by simply adding the component stock prices togetherand dividing by the number of issues. Not terribly sophisticated, but it was a start. Now, at least, comparisons could bemade between past and present, between individual stocks versus the group, and against various economic statistics,such as, say, between railcar loadings or raw materials costs and prices. But mostly it was designed to help the man onthe street monitor the markets general trend. Namely, progressively higher numbers were taken to indicate a bullmarket, while overall declines meant the bear was in session.

Dow Theory and the Birth of Technical Analysis

Useful Market Gauge, or Just a Headline Number?

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Although never actually designated as such by Charles Dow, but instead constructed posthumously by associates andfollowers based on his editorials, what became known as the Dow Theory is widely recognized as one of the earliestmethods to use the markets movements to gauge the health of the business environment. In a nutshell, as Dow believedthat market prices reflect all available information, rising equity quotations presaged improving economic conditions.Likewise, the time to buy stocks was when the Industrial and Rail (now known as Transportation) averages were bothtrending higher, and vice versa.

Changing with the Times

In its earliest incarnation, the Dow included all of the nations existing industrial corporations, outside of the railroadcompanies. In time, Americas manufacturing base expanded, and the index became more of a select representation ofthe entire market. The famous Dow 30 that were all familiar with today didnt come into being until 1928. That was alsowhen it technically stopped being an average. Instead, it began being calculated using a divisor to adjust for stock splits,spinoffs, and substitutions, and to maintain historical continuity.

The 30 components of the Dow Jones Industrial Average are reviewed on an as-needed basis by the editors of the WallStreet Journal and are largely selected for their blue chip qualities. These consist of established, well-regarded, andwidely followed companies with a history of growth and sound financial footing. These are usually the largestrepresentative samples of their particular market sectors, the exception being transportation and utility stocks, which havetheir own indexes.

Since 1928, there have been dozens of changes made to the list, reflecting the evolving makeup of the U.S. economic

landscape. Of the original 30, only two are included today; General Electric (GE - Free Analyst Report), which datesback to the original 12, and Exxon Mobil (XOM - Free Analyst Report), a descendent of Standard Oil.

Standard, Meet Poors

In 1923, Standard Statistics came out with a composite index of 233 stocks. Because of human computational limits, thiswas only published weekly. Realizing the need for more timely data, a slimmer subset of 90 stocks was introduced in1928, made up of 50 industrials, 20 utilities, and 20 railroad issues. This was published daily, and became known as theS&P 90 Stock Composite Index.

About three decades later (and after merging with Poors publishing in 1941), largely thanks to early electronic computersgaining wider usage, the S&P 500 Composite Stock Price Index was introduced. As opposed to a common misconception,

the components are not simply the 500 largest U.S. companies, but are made up of the leading publically traded entitieswithin the important industry groups indicative of the U.S. economic makeup. These are selected by committee, takinginto consideration market cap, financial viability, market liquidity, and industry and sector representation, among otherfactors. The index is reviewed on a regular basis and, because of its larger, more inclusive size, it tends to have far morechanges than the Dow in any given year.

Weighing the Differences

Besides the number of issues represented by each, the major difference between the Dow and S&P is in how they arecalculated. The former is price weighted, so higher-priced issues carry more sway. As such, their importance to the indexwill not be in the same proportion to that of the market at large. So a move in a stock like International BusinessMachines (IBM), currently the highest priced Dow component, will have nearly 12 times the impact of the same move in

Alcoa (AA), which is currently the lowest priced component. Indeed, the 10 highest priced issues account for more than

50% of the indexs movement.

The S&P, meanwhile, goes by market capitalization, which takes into consideration the relative size of a company. That is,

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a stocks price is multiplied by the number of shares outstanding. This total is then divided by an index divisor. As such,the companies that have the highest market caps carry more weight. Even with all this diversification, however, the top 50companies tend to make up more than half the Indexs total value.

Your Mileage May Vary

In addition to the Dow not completely representing the market, being only 30 stocks and all blue chips, and theaforementioned weighting issues that tend to distort the true picture, its use as a measure of historical rates of return alsocomes into question. A quick glance at the Dows long-term price chart shows a generally rising line. However, as withindices in general, over time, it tends to be skewed toward successful companies. Indeed, the Dow from 80 years ago isnot the Dow of today. Once mighty names like, Nash Motors, Radio Corporation, Wright Aeronautical and AmericanSmelting are no longer around, having either merged or gone out of business. As some market pundits have noted, allstocks go to zero in the long run. If you take out all the failures or struggling companies, youre only left with growthstocks. That may be all fine and good for an index, but what if you had actually owned those individual stocks? Yourresults would have been a lot different. The discrepancy may not be significant during a growth cycle, but tends to beamplified during economic downturns. Looking at some current examples, among the more notable recent lineup changes,

American International Group (AIG) was escorted out of the Dow club in September, 2008, followed by Citigroup (C)

and General Motors in June of 2009. If you held onto GM as it went to zero due to bankruptcy, you had a big hole inyour portfolio and had to replace it with actual money, not just a component. So, that seemingly steady long-term climbin the averages doesnt quite tell the story.

Another problem when looking at the long-term trends is that it makes no account for inflation adjustments. From anoriginal level of $40.94 in May 26, 1896, the Dow index has certainly come a long way. But how much would those 40

bucks be worth in todays dollars? Well, taking a nice even number of 3% annual inflation, those original issues shouldtheoretically have been worth about $1,190 this past May. That is, if they were still around. Another issue distortingperformance comparisons is the fact that the frequently quoted S&P and Dow numbers dont include dividends, whichaccount for a large part of long-term investor returns.

A Handy Barometer

To be sure, the Dow Industrials has its flaws. However, its one of the most widely recognized proxies for stock conditions,and it does aim to offer a fairly reliable representation of market movements. For that matter, most any other index madeup of general stocks could serve just as good a purpose, and adding more stocks doesnt markedly improve its utility. Forevidence of this, one need only overlay the charts from various-sized indexes and it will become immediately apparentthat stocks, in general, tend to move in sync. Very rarely will the Dow have a big up day that isnt mirrored in nearly everyother index.

All that Charles Dow was looking for was to create a handy tool that can be interpreted quickly, providing a directionalsense for conditions rather than a detailed analysis. It is kind of like an investment barometer. Every now and then youlook at it to see which way the market weather is going; A simple indicator of whether conditions are getting better orworse. Moreover, being familiar to so many, its a universal language that most will understand. As such, and with all itsflaws, its among the most recognized, closely watched, and quoted indicators of market activity, particularly for thelayman and the media.

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