Fool.com: The Death of the Dow? Hold on a Minute. (Fool on the Hill) March 9, 2000

FOOL ON THE HILL
An Investment Opinion

The Death of the Dow? Hold on a Minute.

By Bill Barker (TMF Max)
March 9, 2000

A quasi-obituary for the Dow Jones Industrial Average (DJIA) was penned today in, of all places, the editorial column of The Wall Street Journal. Since the Journal is owned and published by Dow Jones & Co. (NYSE: DJ), the creator of "the world's most famous stock index," this is worth noting.

OK -- the label "obituary" may be too strong, and burying the Dow certainly wasn't the intent of the author(s) of the editorial. Instead the editorial addressed something that a lot of people have been commenting on lately, which is that there doesn't seem to be a whole lot of correlation between the daily activities of the Dow and the Nasdaq anymore.

The Dow, which has for years been used to answer the question "How did 'the market' do today?" doesn't seem to answer that question quite so well at the moment. At the very least, the performance of the Dow has to be supplemented with a report on what the Nasdaq did to give investors a better idea of how their likely holdings did on a given day.

Questioning the utility of the Dow Jones Industrial Average is always worth doing, and locally we've created our own Motley Fool NOW 50 Index as a potentially superior alternative for investors looking to find today's most relevant companies. (Here, I picture either Bill or Ted congratulating the other, "Dude, the companies in your index are most relevant.") However, if the editorialists at The Wall Street Journal are big enough to question some of the merits of what, legitimately, they call the world's most famous stock index, let us here at The Motley Fool be big enough to raise a little bit of an argument in its defense.

The Dow comprises only 30 companies, which, considering that there are around 7,000 companies in the market doing wildly different things, is an unlikely number to capture the totality of what happens in the market. Nevertheless, check out the results for the Dow over the last 10 years (through December 31, 1999) as it compares to the much broader Standard & Poor's 500 Index and the Wilshire 5000:

               1 Year  3 Years  5 Years  10 Years
DJIA           25.22    78.30    199.84   317.59
S&P 500        19.53    98.35    219.91   315.75
Wilshire 5000  21.44    90.93    202.68   301.87
That's a truly remarkable job over the last 10 years of matching the most popular large-cap index (the S&P 500) and even the entire market. The Wilshire 5000 by now should really be called something like the Wilshire 7000+, but Wilshire 5000 is a lot catchier, and was more accurate at one time.

It is certainly worth noting that the Dow has done this while being a much less actively managed index than either the Wilshire 5000 or the S&P 500. Last year, the only one for which I have data in front of me, the S&P added about 40 new companies. The Dow switched four, which was higher than the S&P on a percentage basis, but was a complete aberration for the Dow when viewed historically. Prior to the move, the most recent change to the Dow had been two-and-a-half years before, on May 17, 1997, and prior to that there had been no change at all to the Dow since 1991. Changing your holdings only three times in a decade, and still beating the market? That isn't Wise at all -- that's pretty Foolish.

All of which might indicate that nothing is particularly "wrong" with the Dow -- that the track record proves it's still a high-quality proxy for the broad market as measured over a period of time that would really tell us something. To the extent that the composition of the Dow could be accused of being well behind the times, the editors of Dow Jones can respond that with the minimum amount of changes and attention, they have almost perfectly captured the entire market's performance -- actually slightly edging the market's returns over the last 10 years.

So the Dow has served quite well over the last 10 years in telling us what was going on in the market, and that was the purpose for its creation. (See our History of the Dow for details.) Knowing what the Dow did on a specific day might not have given you the best idea of what was going on in the broader market, but the Dow index certainly has qualified as a representative index of the market over time.

Nevertheless, the performance of the Nasdaq versus the Dow is remarkable. Consider the following:
              1 Year  3 Years  5 Years  10 Years
Nasdaq         85.59    215.20   441.16   794.71
DJIA           25.22     78.30   199.84   317.59
There's no question that the Dow and the Nasdaq are measuring vastly different things, and the law of averages is not making these two indices match up over time. However, as the numbers above show, the Nasdaq is simply not giving us results measuring what "the market" as a whole does. Looking at the year-to-date numbers, it is still the case that the Dow's results are much more representative of what the market as a whole is doing, even though there are far fewer companies in the Dow than are in the Nasdaq.

The Dow does a pretty good job of capturing the entire market's returns by listing some great companies, and balancing these out with some pretty lousy ones in a proportion equal to what the broader market does. There's a certain utility in keeping companies like International Paper (NYSE: IP), Eastman Kodak (NYSE: EK), and Philip Morris (NYSE: MO) in your average well beyond the point where they appear to be leaders and attractive companies, so that your index doesn't outperform the broader market by being overweighted with excellence. The explicit purpose of the Dow, after all, isn't to outperform the market, but to mirror it.

To best understand the Dow, consider the nomination of Harold Carswell to the Supreme Court by Richard Nixon. When some Senators balked at confirmation due to the fact that Carswell was considered "a boob and a ninny," one of Carswell's defenders countered by saying "even mediocre lawyers and judges deserve some representation on the Supreme Court." Although that argument carried no weight in the confirmation process, it does carry some weight in producing a market index.

Mediocre companies do deserve representation if an index is going to reflect the broader market, which has plenty of both good and lousy companies. In this respect, the Dow is as relevant as ever.