Up, Dow

Editor’s Note: MarketMinder does not recommend individual securities; the below is simply an example of a broader theme we wish to highlight.

The Dow Jones industrial average set a new record, sailing past 2007’s pre-bear market high of 14,164, closing at 14,253 points Tuesday. At first blush, this seems like great news for markets, and folks trumpeted the development far and wide. But our view is the move’s more noteworthy trivia, less meaningful to markets moving forward. Simply, the Dow’s altogether too-narrow construction, arbitrary selection and price-weighting mean it’s far from reflective of US or global markets today.

The Dow receives a lot of attention because it’s historically significant. Founded in 1896, the Dow is the “granddaddy” of all stock indexes, but that’s where its significance ends. Initially, 12 companies comprised the Dow Jones Industrial Average. In 1896, the US market may not have been all that much bigger, and it’s theoretically possible 12 stocks could’ve been considered broad coverage then. (After all, there were only 45 US states at the time.) Since, the Dow’s had replacements and additions, but the number of companies included has remained at 30 since 1928.

Now, including 30 companies in an index was a small sample even by 1928 standards. After all, there were more than 800 stocks trading at the NYSE the following year. And that was with US GDP of just over $100 billion.* In 2012, it was well over $15 trillion, and market growth has vastly outpaced economic growth. Today, there are thousands of publicly traded firms just in the US. Which makes us think 30 companies are a paltry representation of US stocks, not to mention global stocks.

But perhaps more significant than its narrow selection of stocks, the Dow is price weighted—companies with higher share prices affect the Dow’s performance the most, no matter how big the company is or how big its overall economic footprint. Currently, IBM moves the Dow most with its ~$206 price per share; its market cap is a sizeable ~$231 billion. While that’s nothing to sneeze at, consider Exxon Mobil is about as big as they come with a market cap of ~$403 billion, but its per-share price is ~$90. So if Exxon Mobil does well, the Dow reflects its gain much less than it would reflect IBM’s gains—despite the fact Exxon Mobile is almost twice as big as IBM and has more influence on the whole economy. In fact, Exxon’s influence is just above that of Travelers’ Companies—a stock less than one-tenth Exxon’s market cap. In this way, price-weighting moves indexes on a completely arbitrary factor, potentially detaching the index’s returns from the economic reality of its underlying constituents. Hence, the Dow’s not an accurate reflection of the US economy or markets and, therefore, can’t very well indicate future economic or market impact.

If you are interested in a more complete picture of the US economy, we’d recommend going with a broader, market-capitalization weighted index, like the S&P 500—incidentally near an all-time high itself. Even better, go global and follow the MSCI World Index, which measures developed world markets, or the MSCI All Country World Index, which adds in developing nations. Such indexes (logically in our view) weight companies by market capitalization—share price times number of shares outstanding—allowing the biggest companies to move the index most.

But regardless the index, we’ll likely see a lot of all-time-high records broken in the near future, creating an unsurprising pattern, in our view: Stocks at all-time highs generally accompany bull markets, given time. As a result, so do indexes at record highs. The Dow is just an example of that—being a small subset of the US economy, the Dow’s growth reflects US economic strength. (But not the other way around.)

*Source: St. Louis Fed, Link: https://research.stlouisfed.org/fred2.