Useful Market Gauge, or Just a Headline Number?

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Home > Stocks > Commentaries

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 still relevant? Exactly what purpose does it serve? Does it really represent a snapshot of the market? Is it a useful benchmark against which to measure performance? Is it fairly weighted? Do historical comparisons mean anything? How can the individual 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 in 1896, and was made up of 12 stocks. The figure was arrived at by simply adding the component stock prices together and dividing by the number of issues. Not terribly sophisticated, but it was a start. Now, at least, comparisons could be made 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 on the street” monitor the market’s general trend. Namely, progressively higher numbers were taken to indicate a bull market, while overall declines meant the bear was in session. Dow Theory and the Birth of Technical Analysis
http://www.valueline.com/Stocks/Commentary.aspx?id=9337 (1 of 4)8/18/2010 8:58:47 PM

The 30 components of the Dow Jones Industrial Average are reviewed on an as-needed basis by the editors of the Wall Street Journal and are largely selected for their “blue chip” qualities. among other factors. it tends to have far more changes than the Dow in any given year. These are usually the largest representative samples of their particular market sectors. Meet Poors q Related Links Archived Commentaries q The Dow: Useful Market Gauge. The former is price weighted. This was published daily. As opposed to a common misconception. because of its larger. what became known as the Dow Theory is widely recognized as one of the earliest methods to use the market’s movements to gauge the health of the business environment. spinoffs. outside of the railroad companies. their importance to the index will not be in the same proportion to that of the market at large. Of the original 30. the major difference between the Dow and S&P is in how they are calculated.Useful Market Gauge. and widely followed companies with a history of growth and sound financial footing. rising equity quotations presaged improving economic conditions. taking into consideration market cap. Standard Statistics came out with a composite index of 233 stocks.S. the 10 highest priced issues account for more than 50% of the index’s movement. and 20 railroad issues. it began being calculated using a divisor to adjust for stock splits. but are made up of the leading publically traded entities within the important industry groups indicative of the U.valueline. economic landscape.S. companies. and to maintain historical continuity. as Dow believed that market prices reflect all available information. financial viability. The S&P. In time. which takes into consideration the relative size of a company. 20 utilities. which dates back to the original 12. America’s manufacturing base expanded. In a nutshell. goes by market capitalization. and became known as the S&P 90 Stock Composite Index. or Just a Headline Number? Not All Dividends Are Created Equal: Keeping Your Yield Secure Tuesday’s Acquisition Activity Education Stocks Come Under Pressure Big Wave Channel Surfing Entire commentary archive q q q In 1923. Since 1928. meanwhile. The famous Dow 30 that we’re all familiar with today didn’t come into being until 1928. Indeed. That was also when it technically stopped being an average. reflecting the evolving makeup of the U. and vice versa. more inclusive size. so higher-priced issues carry more sway. the components are not simply the 500 largest U. the time to buy stocks was when the Industrial and Rail (now known as Transportation) averages were both trending higher. a descendent of Standard Oil.S. the S&P 500 Composite Stock Price Index was introduced. These are selected by committee.com/Stocks/Commentary. the Dow included all of the nation’s existing industrial corporations. and substitutions. largely thanks to early electronic computers gaining wider usage. well-regarded. this was only published weekly. which is currently the lowest priced component. Changing with the Times In its earliest incarnation. The index is reviewed on a regular basis and. Weighing the Differences Besides the number of issues represented by each. Instead. That is. only two are included today. Because of human computational limits. Standard.aspx?id=9337 (2 of 4)8/18/2010 8:58:47 PM q Subscribe to RSS Feed . Likewise. and Exxon Mobil (XOM . So a move in a stock like International Business Machines (IBM). which have their own indexes. Realizing the need for more timely data. made up of 50 industrials. the exception being transportation and utility stocks. or Just a Headline Number? Although never actually designated as such by Charles Dow. economic makeup. General Electric (GE . currently the highest priced Dow component.Free Analyst Report). These consist of established. http://www. a slimmer subset of 90 stocks was introduced in 1928.Free Analyst Report). About three decades later (and after merging with Poor’s publishing in 1941). and the index became more of a select representation of the entire market. and industry and sector representation. As such. will have nearly 12 times the impact of the same move in Alcoa (AA). but instead constructed posthumously by associates and followers based on his editorials. market liquidity. there have been dozens of changes made to the list.

This total is then divided by an index divisor. A Handy Barometer To be sure. Another problem when looking at the long-term trends is that it makes no account for inflation adjustments. and adding more stocks doesn’t markedly improve its utility. Wright Aeronautical and American Smelting are no longer around. it tends to be skewed toward successful companies. Radio Corporation. Indeed. But how much would those 40 bucks be worth in today’s dollars? Well. As such. it’s among the most recognized. 2008. most any other index made up of general stocks could serve just as good a purpose. It is kind of like an investment barometer. and quoted indicators of market activity. however. If you take out all the failures or struggling companies. the companies that have the highest market caps carry more weight. or Just a Headline Number? a stock’s price is multiplied by the number of shares outstanding. all stocks go to zero in the long run. the top 50 companies tend to make up more than half the Index’s total value. as with indices in general. A quick glance at the Dow’s long-term price chart shows a generally rising line. its use as a measure of historical rates of return also comes into question. However. it’s one of the most widely recognized proxies for stock conditions. American International Group (AIG) was escorted out of the Dow club in September. Another issue distorting performance comparisons is the fact that the frequently quoted S&P and Dow numbers don’t include dividends. it’s a universal language that most will understand. Every now and then you look at it to see which way the market weather is going. particularly for the layman and the media. having either merged or gone out of business. Copyright © 2010 Value Line. However. the Dow Industrials has its flaws.aspx?id=9337 (3 of 4)8/18/2010 8:58:47 PM . So. closely watched. followed by Citigroup (C) and General Motors in June of 2009. From an original level of $40. 1896. if they were still around. All that Charles Dow was looking for was to create a handy tool that can be interpreted quickly. Moreover. you’re only left with growth stocks. If you held onto GM as it went to zero due to bankruptcy. being only 30 stocks and all blue chips. Nash Motors. Terms| Privacy| Support| Contact Us| http://www. one need only overlay the charts from various-sized indexes and it will become immediately apparent that stocks. which account for a large part of long-term investor returns. That may be all fine and good for an index. Once mighty names like. For that matter. the Dow index has certainly come a long way.valueline. Looking at some current examples. That is. over time. but what if you had actually owned those individual stocks? Your results would have been a lot different. among the more notable recent lineup changes. that seemingly steady long-term climb in the averages doesn’t quite tell the story. being familiar to so many.Useful Market Gauge. the Dow from 80 years ago is not the Dow of today. and with all its flaws. those original issues should theoretically have been worth about $1. A simple indicator of whether conditions are getting better or worse. As such. tend to move in sync. As some market pundits have noted. Inc. and it does aim to offer a fairly reliable representation of market movements.com/Stocks/Commentary. and the aforementioned weighting issues that tend to distort the true picture. For evidence of this. taking a nice even number of 3% annual inflation.190 this past May.94 in May 26. you had a big hole in your portfolio and had to replace it with actual money. The discrepancy may not be significant during a growth cycle. in general. not just a “component”. Very rarely will the Dow have a big up day that isn’t mirrored in nearly every other index. Even with all this diversification. Your Mileage May Vary In addition to the Dow not completely representing the “market”. but tends to be amplified during economic downturns. providing a directional sense for conditions rather than a detailed analysis.

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