The Dow Jones Industrial Average (INDEX: ^DJI ) is the most widely quoted measure of the U.S. stock market, yet it is terrible at its job. Read along and I'll explain why the Dow is a poor measure of the U.S. market. I'll also share a surprising stat that might change your mind on the state of the U.S. market and tell you how you can profit from all this.
The Dow Jones Industrial Average is an index of just 30 stocks whose stated goal is "to provide a clear, straightforward view of the stock market and, by extension, the U.S. economy." Started in 1896 by financial journalist Charles Dow, the Dow is weighted by the stock prices of its component companies and nothing else. To calculate, you simply add up the 30 stock prices and divide the total by the Dow Divisor. When the index was formed, the divisor was 30, but after 116 years of stock splits, dividend payments, and component changes, it currently stands at 0.132129493.
This method is a relic of the pen-and-paper times the Dow was invented in, when it was much too complicated to use the more rigorous methodologies of the S&P 500 or the Wilshire 5000. The simplistic weighting has led to ridiculousness such that IBM has more than twice the effect of ExxonMobil on the Dow, even though Exxon is nearly twice its size. The outsized effect of just a few stocks is a major problem, as many people's perception of the state of the U.S. economy is based on the Dow.
The state of the market
After a crazy 2011, the Dow has been trending slowly upward and currently sits just barely above its 2008 level.
Dow Jones Industrials Stock Chart by YCharts
But is this truly the state of the market? In the late spring of 2009, Dow component General Motors (NYSE: GM ) was on its way to bankruptcy, which meant it would have to be taken out of the index. Many people expected GM to be replaced with Apple (Nasdaq: AAPL ) , as it was a tech bellwether. Instead, the Dow powers-that-be ended up choosing Cisco (Nasdaq: CSCO ) in June 2009, and that's how we have the Dow as we know it today.
The Dow that didn't happen
It's interesting to consider what could have been. Apple has been on a tear the past few years and has become the largest publicly traded company in the United States. Bespoke Investment Group crunched the data on what the Dow's performance would look like if Apple had been included instead of Cisco.
Source: Bespoke Investment Group.
Imagine how the market itself would be different had Apple been included. A few months ago, the Dow would have broken its all-time high of 14,164 and as of early February would have been at 14,636! Pundits would be screaming about how it is such a great time to invest. Dow Soars Above 14,000! Dow at an All-Time High! Dow 15,000! Companies would be hiring more people and buying back stock in droves as confidence grew with the rising stock prices.
Yet the fact that the Dow can be altered so heavily by just one stock is exactly why you shouldn't rely on the Dow. It's not just Apple that would have changed the Dow so mightily, either. The index also would have been way up had Ford (up 116%) or Amazon.com (up 140%) been included in place of General Motors since June 2009.
People pay attention to the Dow out of habit, as Dow Jones itself explains on its website:
The Dow Jones Industrial Average is the most-quoted market indicator in newspapers, on television, and on the Internet. Because of its longevity, it became the first to be quoted by other publications. This practice became habit when Wall Street earned at least a mention in the general news each day, and habit became tradition when the post-World War II bull market commanded the nation's attention. The Industrial Average became the indicator to cite if you were citing only one.
Like cursive writing, the imperial measurement system (how many inches are in a mile again?), the QWERTY keyboard, and other terrible ideas we continue to use just out of habit, the Dow should be phased out of existence. There are better measures out there of the state of the market, like the S&P 500, that are less prone to the swings of just a few stocks.
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