What the Dow's New High Means

Nothing. Let me repeat: The record highs consecutively achieved by the Dow Jones Industrial Average (DJIA) on Tuesday and Wednesday mean nothing of any consequence.

That probably wasn't the answer you were looking for when you clicked on the link to this article. However, despite the hundreds of articles anticipating or recounting this "event," and the feverish attempts to decode market "sentiment" or "leadership," the fact remains:

The DJIA is flawed
One of the only thoughtful pieces I've seen on the Dow's new high appeared in the Lex column of the Financial Times (FT), noting the major flaws inherent in this index (something longtime Fool contributor Selena Maranjian called attention to in 2003). Despite its popularity, it's plainly unrepresentative of the national economy or the stock market. The full index name, Dow Jones Industrial Average (maintained by Dow Jones (NYSE: DJ  ) ) should give you a hint which sector it favors. Based on the weightings for the DIAMONDS and Standard & Poor's Depositary Receipts ETFs (as of Mar. 31, 2005), the Industrial sector's weighting is approximately 29%, whereas it represents only about 12% of the broader-based S&P 500 index.

Second, the Dow is price-weighted, meaning that the weight of each stock that makes up the index is determined by the stock's price (in a value-weighted index, such as the S&P 500, a stock's weighting is determined by the company's total market capitalization). Constructing a price-weighted index is equivalent to tracking a portfolio that contains a single share of each stock, regardless of price. Value-weighted indexes are simply better conceived to track the performance of the overall market or specific market sectors. As the Financial Times noted, "the biggest factor in [the DJIA index's] resurgence since 2000 has been Caterpillar. The construction equipment maker was not even in the top 15 most influential stocks driving the S&P 500."

Finally, if you are a passive index investor, why would you want to match the DJIA rather than the S&P 500 (or another broad market index)? Tracking only 30 stocks looks like an active strategy to me, regardless of whether they have the size or pedigree of General Electric (NYSE: GE  ) , Citigroup (NYSE: C  ) or Microsoft (Nasdaq: MSFT  ) . Perhaps readers can enlighten me here.

Highs, lows, and magical thinking
Beyond the dry technical aspects of index construction, there is another "softer" point relating to our curious obsession with new market highs. There is nothing of much use to conclude from the market's new high -- it's a completely pedestrian observation (thinking strictly in terms of the absolute level, whether a new high or otherwise, is much more useful). Still, people desperately seem to want to extract some meaning from the event -- a form of magical thinking practiced by many technical analysis cultists ... I mean, chartists. On a related note, I can recommend a recent paper from Professor Roy Batchelor of the Cass Business School in London. Professor Batchelor looked at the series of daily DJIA prices between 1915 and 2003 and could find no evidence that price trends were consistent with the Fibonacci ratios of which technical analysts are so fond.

Related Foolishness:

Whether the market is at new highs or lows, stick to the fundamentals! To find out which stocks Inside Value head analyst Philip Durell is currently recommending in his fundamentally sound value investing newsletter, try a 30-dayfree trialto the service. Microsoft just happens to be an Inside Value recommendation.

Fool contributor Alex Dumortier owns shares of Microsoft, but no shares of any other companies mentioned in this article. He welcomes your (constructive) feedback. The Motley Fool has a strict disclosure policy.


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