FYI | Feb 23 2009
By Greg Peel
There is little doubt the Dow Jones Industrial Average is the iconic, bellwether indicator of the state of the US economy, and thus the global economy. Where go the fortunes of the Dow, so go the fortunes of the world, at least in the eyes of market-watchers. But to a great extent the DJIA has become an anachronism.
The Dow was first published in 1896 by Charles Dow, founder and editor of the Wall Street Journal and co-founder of Dow Jones & Company. It initially contained twelve stocks, of which General Electric is the only remaining, stand-alone component. (Other companies have merged and split over time, or have simply been replaced). It was not the first index the WSJ published – that was the Dow Jones Transport Average. Late in the nineteenth century, the US stock market was all about railroads. But toward the turn of the century the US was swept up in the Industrial Revolution as new inventions became household items and construction was abundant. So was born the DJIA.
The Dow is a simple arithmetic price average. This sets it aside from the Standard & Poor’s index of 500 stocks (the S&P 500) which was introduced in 1957. The S&P is a market capitalisation-weighted index. This means that the larger the stock by market cap, the more weighting it receives in the index valuation. Australian indices, such as the S&P/ASX 200, are similarly weighted. The Dow gives no more than equal weighting to any one stock, which today number 30 within the average.
It is for this reason that stock market traders, fund managers and analysts largely ignore the Dow, seeing it as simply a rough indicator of market sentiment, as opposed to the S&P which is the more accurate measure of the broad US stock market’s movements. The Dow enjoys historical status, but is really only a curiosity.
Mind you, market-capitalisation indices are not without their own problems. Consider that the bulk of equity investment by managed funds is executed on an index-weighted basis. This means that every quarter, or maybe even more frequently, fund managers have to buy those stocks which have increased in market weight and sell those that have reduced. Now if a lot of money is thrown behind these adjustments, what’s going to happen? Well – the larger stocks will see their prices rise and the smaller stocks will see their prices fall, all things being equal. This increases/decreases respective market capitalisations, so then fund managers have to buy more and sell more again. It is a rather self un-correcting process.
Nevertheless, it is still preferred to the DJIA’s thirty stock prices divided by thirty. But now that the GFC has wreaked havoc on stock markets, there are more problems to consider for the Dow as well.
The Dow is an index created, managed and published at the discretion of a media company. Its components are supposed to be the largest and most widely-held companies in the US, but there are no real rules about that. The S&P 500, on the other hand , is managed by a ratings agency which sets specific rules about market cap and liquidity, and conducts promotion and relegation of stocks every quarter. The components of the Dow are changed only on occasion, and then only at the discretion of the journalists. The intention is to create an index which is representative of the biggest companies in the US at the time.
For that reason, the “Industrial” tag in the DJIA is no longer particularly relevant as intended, for today the components include banks, technology companies, pharma and food companies. The most recent replacement occurred last year when insurance giant AIG was quasi-nationalised and thus replaced by Kraft. Last year also saw Bank of America replace engineering and aerospace conglomerate Honeywell. Honeywell was actually performing a lot better than B of A at the time, but the Dow Jones people thought that as “industrial” companies had become less of an influence on the market, and financial companies more, the switch was justified.
It is for the same reason you will see the likes of Microsoft and Intel in there alongside stalwarts AT&T, Exxon and Coca-Cola.
It is the “representation” factor, in contrast to simple price, which is now causing controversy. Three companies are now trading at below US$5 per share – Citigroup, the aforementioned newbie Bank of America, and General Motors, which has been in the index since 1925. What this means, as Associated Press pointed out last week, is that if all three stocks were to trade to zero, the DJIA would fall less than 1%. What, then, is the point of having these stocks in the index? How are they representative?
Even the man charged with maintaining the index for Dow Jones – John Prestbo – agrees that it is “very subjectively run”. Prestbo told AP that while Dow Jones has no intention to stand by these three stocks “come hell or high water”, they are still representative of what’s going on in the US economy at present, even if not representative of the “largest” companies.
There is little doubting that banks are currently a very important part of the US economy. But are they an important part of the stock market anymore? Most have seen their share prices fall 70-90%. Indeed, if you add up the market cap of the 24 stocks in the S&P banking index, that total is still only about two-thirds of the market cap of Exxon. But you will still hear media comments suggesting “Wall Street was weak today, led down by the banking stocks”. It may well be that banking stock prices were leading sentiment, but the truth is they’re no longer having much of an individual impact on indices.
In its halcyon days, GM was considered almost a stand-alone bellwether for the US economy. “What’s good for GM is good for America” was a common expression in the 1950s, lampooned by Joseph Heller in “Catch-22”. But GM shares have fallen from US$94 at their peak to under US$2 today. While Americans may care considerably what happens to GM, the stock market shouldn’t care at all. GM can barely move the DJIA a point.
Why then, do we live and die every day by movements in the Dow? Last week saw another one of Charles Dow’s inventions – Dow Theory – suggest a technical level was breached in the DJIA which implied another big down Dow leg to come. This may yet prove to be true, but Dow Theory has probably proven about 50% accurate over time. The S&P 500 has not (yet) reached a breach.
It has become noticeable over recent weeks that the Dow and S&P 500 will vary significantly in movement. When I say significantly, I mean something like a 1.5% fall for the former and a corresponding 2.5% fall for the latter. Clearly the two indices would have a correlation factor in the high 90 percents. But obviously index make-up is now having an effect.
The moral to this story? None really, except always accept the Dow Jones Industrial Average for what it is – more of a totem than a totalisator.
