March 29, 1999

How Now 10K Dow?

By Dale Wettlaufer (TMF Ralegh)

The Following Article Initially Appeared in the March 12th Lunchtime News

The Dow's going to 10,000! The Dow's going to 10,000! If I were on the committee at Dow Jones that decides what companies get included in its century-old Industrial Average, I'd split the divisor just out of a sick sense of humor. I guess no one would be celebrating the 10,000 mark, though, which means less publicity for Dow Jones. Remember, the Dow Jones Industrial Average is a publicity thing. It's not necessarily the best index of what is going on in the stock market or corporate America. Like the QWERTY keyboard, though, it's the standard index of market activity that is quoted by almost all news outlets.

When you hear about how the Dow has done over the years, it doesn't give you the best or even an accurate indication of how an investor would have done over that period. For instance, although the Dow index has experienced years of flatness at times, the index does not reflect the payment and reinvestment of dividends. For instance, over the last 18 years, the S&P 500 has advanced at a compound annual rate of 13.12% per year. Reinvesting dividends, however, especially at market lows, compounds your returns. Over the last 18 years, the compound annual return on the S&P 500 with dividends reinvested was 16.98%. That's a gigantic difference over 18 years. Here's an example of how this works: Had you started an index at 1,000 without reflecting the reinvestment of dividends, the index would be at 9,198 today. If you had constructed an index that did reflect reinvestment of dividends, the index would be at 16,827 today. That's a pretty substantial difference between the two and points to the vulnerability of price indexes telling the whole story on investors' returns.

Finally, when you see stories about the Dow and the S&P 500's advance over the last three years, consider that the S&P 500 isn't the entire market. When you look at the 9.5% compound annual return (with dividends reinvested) over the last three years on the Russell 2000 (the bottom 2,000 stocks of the 3,000 largest publicly traded companies), you should realize that it's the creme de la creme of American corporations that are enjoying super-normal returns right now -- not the smaller companies.

Some people will chalk it up to liquidity conspiracies and large-cap bubbles. The fact is that the cream of the crop of American corporations are the most competitive companies in the world that are reaping excellent rewards from: 1) investments in process-enhancing technologies that speed up asset turns; 2) a lower cost of capital than smaller companies; and 3) Better margins. The pricing of larger corporations also reflects investors' expectations that these companies will be able to capitalize on global growth. After all, the vast majority of Coca-Cola's profits come from overseas and the vast majority of its investments are being made overseas.

So, the entire market is not going up at a breakneck rate. Dow 10,000 is not as significant as it seems, because the longer-term investors (I'm talking about people in the market for 10 and 20 years) who have reinvested dividends, even after paying taxes, saw their account values (if indexed) pass Dow 10,000 long ago.