Thursday, March 05, 2009

I don't give a damn about the Dow

I've written before about how the "experts" do their best to hide the most factual and useful data by promoting fanciful or useless data. For instance, it's easy to find P/E ratios for stocks using operating earnings, but not so easy to find the numbers with real as-reported earnings. Similarly, when the stock buyback craze swung into full gear in the middle of this decade, pundits suddenly started singing the praises of buybacks while ignoring the historically low (and worthless) dividend yields.

The talking heads do the same thing when it comes to stock market indexes. No matter whether you get your stock market news from TV, radio, the internet or the printed page, the first number you probably see or hear is the Dow (the Dow Jones Industrial Average), which has become the standard gauge for "how the market is doing." The Nasdaq is usually the second number reported, and if you're lucky you might get as an afterthought the value of the S&P 500 index. Not surprisingly, it is this last and least-followed number which actually matters.

The Dow Jones Industrial Average suffers from two fundamental flaws. First, the 30 companies whose stock prices are used to calculate the average are chosen somewhat arbitrarily. Sure, its 30 members are among the largest companies, but they are not the largest, and therefore are not as representative of corporate America as one might think. Among the top-30 companies which aren't in the Dow are Cisco, Apple, Google, PepsiCo, and Philip Morris. Conversely, several companies which are in the Dow 30 are quite small by comparison, like DuPont (87th largest), Caterpillar (98), American express (103), and Alcoa (243).

The second problem with the Dow is how the index average is computed. The stock prices of the 30 companies are weighted, not by the size of each company, but by the price of a single share of stock, which is a meaningless number. So IBM, the 7th largest corporation in America, has the greatest weight in the Dow 30 index (10% of the total) because its share price is $88. Meanwhile, AT&T and Microsoft, the 4th and 5th largest corporations in the U.S., are only ranked 16th and 22nd in the Dow, respectively, counting less than 3% each towards the total.

By comparison, the S&P 500 index is a far more logical, meaningful, and useful measure of the stock market. Not only is the S&P comprised of 500 companies instead of the paltry 30 in the Dow, but the contribution of each stock in the index is weighted by the size of the company. More specifically, each company in the S&P is weighted by its market capitalization, which is the total price of all of the shares of stock, or the amount of money required to buy the entire company at its current share price.

The membership of the S&P 500 is also more logical and relevant. With only a few exceptions, the 500 corporations in the S&P are the largest 500 stock-issuing companies in the country, accounting for approximately 78% of the entire net worth of all stocks traded in the U.S. markets. (The largest corporation not included in the index is Berkshire Hathaway, whose class-A shares are worth $72,000 each today, thus placing it in a very exclusive market that most investors can't participate in anyways.)

For these reasons, I use the S&P 500 index to follow the stock market instead of the Dow Jones Industrial Average. Sure, the Dow still has some use in historical studies (it's a few decades older than the S&P) and as a sentiment gauge, (more people pay attention to it) but it's simply inferior to the S&P 500 when it comes to tracking the overall U.S. stock market.


Anonymous said...

You just nailed another great insight for us. Once the truth is pointed out, it seems so simple.
However, financial section of USA Today, Wall Street Journal, Jim Cramer, and your local broker don't seem to know the real truth.

Thanks for another great blog post that increases our knowledge and understanding of the market.
Keep it up!!

Tim said...

Excellent Post.

Hanging on for DOW life...

adventurerneil said...

Jon Stewart had a great rant about the market in general (and Dow in particular) tonight on his show. Stephen Colbert also picked up on the doom and gloom.

Watch the vids embedded in my CAPS blog.