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Why the Dow Jones Industrial Average Is the Most Misused Index

This is a syndicated repost published with the permission of Money Morning. To view original, click here. Opinions herein are not those of the Wall Street Examiner or Lee Adler. Reposting does not imply endorsement. The information presented is for educational or entertainment purposes and is not individual investment advice.

The Dow Jones Industrial Average has been viewed as a barometer for the U.S. stock market’s performance since it was created on May 26, 1896.

It’s the most widely recognized stock market index in the world and is almost always referenced when analysts and investors discuss the “stock market” in any form.

Dow Jones Industrial Average

Jun 23 03:11 PM
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Price: 16,923.00 | Ch: -24.08 (-0.1%)

But should it be?

To understand the best way to use the Dow Jones today, it’s important to look back at the history of the index.

How the World’s Most Popular Index Came to Be

Before the Dow Jones Industrial Average (DJIA) was created, there was Dow Jones & Company, founded in 1882 by journalist Charles Dow, statistician Edward Jones, and journalist Charles Bergstresser. Financial publishing firm Dow Jones & Co. is best known as the predecessor of The Wall Street Journal.

Dow Jones Industrial AverageSeveral years later, Charles Dow was looking for a way to accurately track the performance of the stock market, so he selected 12 stocks and created the Dow Jones Transportation Average on Feb. 16, 1885. At the time, the index consisted of 10 railroad stocks and two industrial stocks.

By the time 1896 rolled around, Dow realized that industrial companies had a much stronger bearing on the market’s performance, so he created a new index with 12 industrial stocks. Originally, most of the DJIA’s stocks were large commodities companies that were well respected in the markets.

On May 26, 1896, the Dow Jones Industrial Average was born.

To calculate the DJIA’s performance, Dow averaged the prices of all 12 components. The first total Dow calculated was $40.94, and that was the first value of the Dow Jones Industrial Average.

More than 115 years later, the Dow Jones is still the most closely followed market index in the world – but the man who created it more than a century ago might not even recognize it now…

Frontrunners Added, Laggards Dropped

In the 118-year history of the Dow Jones Industrial Average, there have been 50 changes made to the index.

Where there once were 12 industrial stocks in 1896, there are now 30 stocks that represent a wide swath of industries from entertainment to healthcare to energy. Each stock trades on either the New York Stock Exchange or the Nasdaq.

Because the DJIA was created to give investors a snapshot of the broader stock market, companies can be removed when they no longer have a strong bearing on the U.S. economy. For instance, some companies have been removed due to advances in technology, whereas others have been taken off because the stock has vastly underperformed.

One of the most notable recent changes to the DJIA was the removal of General Motors Co. (NYSE: GM) shortly after it filed for bankruptcy protection in 2009. GM had been a member of the DJIA for 94 years but was removed after posting a loss of 87% in 2008.

If an industry no longer has a strong bearing on the U.S. economy, companies from more burgeoning industries may be added.

The Eastman Kodak Co. was removed from the DJIA in April 2004 after spending nearly 75 years on the index. A pioneer in the consumer camera and film industry, the company did not adapt quickly to digital camera technology and was removed from the index. Whereas Kodak had traded just below $80 per share in 1999, the stock was worth less than $26 per share when it was delisted.

The numerous changes made to the index have kept it climbing higher throughout much of its 118-year existence and brought us to where we are today, on the verge of 17,000 points.

But these changes have also brought the index a fair amount of criticism. Charles Dow may have created the DJIA to provide a snapshot of the broader stock markets, but today, the index does not achieve that goal…

Dow Changes Have Completely Skewed the Index

When a change was made to the index in 2004, Dow Jones Indexes Editor John Prestbo said, “There are no predetermined criteria for a stock to be added or deleted, though we intend that all components be established U.S. companies that are leaders in their industries.”

But critics of these moves have pointed out that underperforming stocks have been removed in favor of stronger stocks. This skews the index’s performance and creates an inaccurate picture of how U.S. stocks are doing.

Just look at the DJIA’s most recent readjustments. It removed Alcoa Inc. (NYSE: AA), Bank of America Corp. (NYSE: BAC), and Hewlett-Packard Co. (NYSE: HPQ) in favor of Goldman Sachs Group Inc. (NYSE: GS), Nike Inc. (NYSE: NKE), and Visa Inc. (NYSE: V) on Sept. 20, 2013.

The three added companies averaged a share-price gain of 44% in the year prior to their addition. The companies removed had averaged a gain of just 17% in the year before they were removed. During the same time, the entire Dow had gained 14%.

The fact that strong-performing stocks are commonly added to the Dow at the cost of lesser-performing stocks has caused many to question the validity of the Dow Jones Industrial Average as a true barometer of the stock market’s performance…

Money Morning reader Wim Grommen, a mathematics teacher in the Netherlands who has studied the peculiarities of market indices for the past 15 years, wrote to us about this pattern in April.

“The manner in which the Dow index is maintained actually creates a kind of pyramid scheme,” Grommen explained. “All goes well as long as companies are added that are in their take-off or acceleration phase in place of companies in their stabilization or degeneration phase… It greatly increases the chance that the index will rise rather than go down.”

Money Morning‘s Chief Investment Strategist Keith Fitz-Gerald has talked about this numerous times and agrees.

And that’s not the only criticism of the Dow Jones…

The Dow Jones Industrial Average Is Weighted All Wrong

Another major criticism of the Dow stems from how the components are weighted.

Companies in the Dow Jones are weighted by share price, not by market capitalization. That means the stocks that have a greater share value have more influence on the average’s performance. When one of the larger companies in the index experiences a large swing, the index tends to move accordingly.

For instance, Goldman Sachs Group Inc.’s (NYSE: GS) $170 share price and $76 billion market cap have more of a bearing on the DJIA’s performance than Exxon Mobil Corp.’s (NYSE: XOM) $102 shares and $440 billion market cap.

That’s why it would be almost impossible to add Google Inc. (Nasdaq: GOOG, GOOGL) and its $560 share priceor Apple Inc. (Nasdaq: AAPL) and its pre-stock-split $625 shares to the Dow Jones Industrial Average. While these are two of the largest companies in the United States, and bellwethers for the entire tech industry, adding them to the DJIA would completely disrupt the balance of the index.

There’s a Better Way to Measure the Market

Today, investors who want a quick summary of the market’s performance are better off following the Standard & Poor’s 500 Index.

As its name suggests, the S&P 500 is a market index that tracks 500 large companies that either trade on the NYSE or Nasdaq. Unlike the DJIA, the S&P 500 is weighted by market capitalization, not stock price.

The S&P 500 was first introduced on March 4, 1957. The components of the index represent every major industry and must meet numerous criteria that deal with market capitalization, trading frequency, and liquidity-based requirements.

“Most money managers benchmark themselves against the S&P,” Robert Kaplan, former vice chairman at Goldman Sachs, told CNBC. “If you want to buy emerging companies, you’re much more likely to find them among the S&P than you are among the Dow. [Even though] you might get some laggards in the S&P. You’re not likely to get those in the Dow.”

Adam Davidson of The New York Times has pointed out that even the aforementioned Dow Jones Index Editor John Prestbo wouldn’t use the DJIA as a true indicator.

“Prestbo says the average investor should observe the Dow once a quarter or, at most, once a month,” Davidson wrote in 2012. “He also cautions against drawing broad conclusions about the overall health of the economy from any narrowly focused stock average.”

When looking for a good snapshot of the stock market’s performance, the S&P 500 offers a broader and more accurate look than the Dow Jones Industrial Average.

Do you invest in any of the components of the Dow Jones Industrial Average? Join the conversation on Twitter @moneymorning using #DowJones.

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The post Why the Dow Jones Industrial Average Is the Most Misused Index appeared first on Money Morning

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