"DOW TOPS 13,000 FOR FIRST TIME," the headlines shrieked last week. "NEW HIGH FOR MARKETS," barked the TV talking heads, breathless over this big milestone for the U.S. stock market.
But in many of those news stories -- albeit in later paragraphs -- there was a quote or two from a Wall Street pro who just didn't seem to be all that excited about the development. In fact, many seemed to think it was a meaningless milestone.
So is this classic index really worth the attention it gets?
What it is
As all Fools know, the Dow -- properly known as the Dow Jones Industrial Average, one of several indices maintained by Dow Jones (NYSE:DJ), publisher of The Wall Street Journal -- tracks the composite performance of 30 of the largest public U.S. companies. The Dow has been published since 1896, and its components are updated regularly. General Electric (NYSE:GE) is the only stock that has been part of the index since the beginning, when its members were all old-line industrial firms.
Today, in addition to traditional smokestack stocks such as Caterpillar (NYSE:CAT) and Boeing (NYSE:BO), the index also includes the likes of Disney (NYSE:DIS) and McDonald's (NYSE:MCD), companies that possess few attributes of past Dow components -- all in an effort by the Dow to present itself as a broad-based proxy for the U.S. markets. Dow Jones adds and drops stocks to the index every few years, and the composition and coverage of the index has varied quite a bit over time.
What it isn't
Criticisms of the Dow center on two issues. First, with only 30 components, all of which are very large-cap stocks, the Dow can't hope to capture the ups and downs of the overall U.S. market as well as a broader-based index, such as the S&P 500 can. Second, the Dow is a price-weighted index, meaning that it is computed by adding the stock prices of the 30 member companies and dividing by a predetermined "divisor." In practice, what this means is that a $100 stock has five times the impact on the index as a $20 stock, even if the company with the $20 stock is much larger.
Yet most indices -- certainly most of the ones that savvy investors take seriously -- are capitalization-weighted, meaning that the price movements of the largest companies (by market cap) have the largest impact on the index. General Electric, for instance, with a market cap roughly 2.5 times that of IBM, has about 2.5 times IBM's impact on a capitalization-weighted index like the S&P 500. Given that GE is a larger company and makes a larger contribution to the U.S. economy, this approach seems to make sense.
But the Dow thinks otherwise. As I write this, GE is trading at around $37, and IBM -- currently the highest-priced stock in the Dow -- is trading near $102. So the Dow is giving GE just 36% of the weight it gives IBM. That means a 2% change in IBM's share price will affect the Dow more than twice as much as a 2% change in GE's price.
Stock splits mess things up even further. If tomorrow, out of the blue, GE's board of directors were to approve a 2-for-1 stock split, then GE would only have 18% of IBM's impact on the Dow, even though GE is a far larger company and even though none of its fundamentals would have changed. Although Dow Jones changes the index's divisor after splits to keep the overall level of the index constant, the weightings of the components do change.
For a little mental fun, imagine the madness that would ensue if the powers-that-be at Dow Jones decided to add Berkshire Hathaway (NYSE:BRK-A), currently trading at a little more than $109,000 per share, to the index. The price movements of the other 29 companies would scarcely be noticeable.
Should we care?
Obviously, if you're looking for a benchmark for your portfolio, something to judge your stock picking (or your mutual fund holdings) against, price-weighted indices such as the Dow aren't a good choice. The S&P 500 and other broad-based, capitalization-weighted indices present a fairer picture of the ups and downs of the markets. And likewise, if you're just looking to see "what's going on in the markets today," your first glance will be more useful if it's directed at the S&P 500 and the Nasdaq Composite.
So, should a Fool pay attention to the Dow at all? Some, including famed investment manager and pundit Ken Fisher, say no. Fisher suggests that investors train themselves to tune the Dow out entirely. Others note that it's somewhat useful as a measure of sentiment, and it does generally tend to move roughly in sync with measures such as the S&P 500 over time. If you consider it useful, by all means follow it. But don't be too swayed by the breathless hype when it hits 14,000 -- or 11,000.
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Fool contributor John Rosevear owns shares of Berkshire Hathaway but does not own any of the other companies mentioned. Disney is a Stock Advisor pick, while Berkshire Hathaway is an Inside Value recommendation. The Motley Fool has a disclosure policy.
