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KIM: Dow milestones get headlines but don't reflect overall market

February 25, 2017

KimEven casual stock market observers know the Dow Jones industrial average closed above 20,000 for the first time on Jan. 25. U.S. stocks have enjoyed a massive rally since the DJIA closed at 6,547 on March 9, 2009, even as it closed at 15,660 (a two-year low) as recently as Feb. 11, 2016.

The DJIA is the default, shorthand answer to the question, “What did the market do today?” While the DJIA is iconic and the most commonly referenced stock market benchmark, you might not know how it began or its flaws as a measure of the overall stock market.

According to The Wall Street Journal, the DJIA was created by Charles Dow—the publication’s first editor and co-founder of Dow Jones & Co.—to illustrate stock-market movements to his readers. The first iteration of the DJIA was printed in the journal’s predecessor publication in 1884 and averaged the closing prices of 11 stocks—nine railroads, one steamship company and Western Union.

The Wall Street Journal itself launched in 1889 and a 12-member DJIA composed of “smokestack” industrial companies was first published on May 26, 1896. The DJIA was expanded to 20 stocks in 1916 and 30 “blue chip” stocks in 1928, where it remains today.

Although the DJIA remains a ubiquitous part of stock market lexicon, it has two major shortcomings that cause professional investors to use indexes like the S&P 500 (500 stocks, representative of the U.S. market for large stocks) or Russell 3000 (3,000 stocks, representative of the overall U.S. stock market) as performance benchmarks.

First, the DJIA contains only 30 stocks, which obviously represents a much narrower sample than either the S&P 500 or Russell 3000.

Second, while both the S&P 500 and Russell 3000 are market-capitalization-weighted indexes (market capitalization is simply the number of shares outstanding multiplied by price), the DJIA is a price-weighted index, which means the performance of stocks with the highest dollar price have a much bigger impact than those with the lowest prices. For example, at $250 per share, Wall Street titan Goldman Sachs has the highest price of the 30 stocks (8 percent weighting), while General Electric, at $30 per share, has the lowest price (1 percent weighting).

To understand the absurd and arbitrary nature of price-weighting, if Goldman had twice as many shares outstanding, priced at $125 instead of $250, its market capitalization would remain the same, but its weighting in the DJIA would be halved to 4 percent. Further, Apple, at $135 per share, has the biggest market capitalization in the United States and its S&P 500 weighting (3.6 percent) is seven times larger than Goldman’s. Yet it has half Goldman’s impact on the DJIA.

Indeed, according to The Wall Street Journal, Goldman’s 30 percent rise since Nov. 8, as it miraculously transformed from pre-election pariah to post-election darling, contributed 21.9 percent of the 1,736-point gain in the DJIA since Election Day.

It took 76 years for the DJIA to close above 1,000, which it reached on Nov. 14, 1972. When I started in this business in August 1982, the DJIA was around 800 (no typo). The first close above 5,000 was on Nov. 21, 1995, 10,000 on March 29, 1999, and 15,000 on May 7, 2013.

Crossing DJIA milestones is fun, but remember the DJIA’s flaws make it a good directional indicator of stock prices, not a measure of the overall stock market.•

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Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC. He can be reached at (812) 376-9444 or mickey@kirrmar.com.
 

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