Time to Disavow the Dow Right Now? 01.14.2022
The oldest and still most widely quoted proxy for the U.S. stock market, the Dow Jones Industrial Average (DJIA), or “the Dow” for short, continues to be regularly quoted by news broadcasts, newspapers, and smartphone apps as an indicator of the health (or lack thereof) of the financial markets and U.S. economy.
The Dow history is interesting, as it was created in the late 19th century by Charles Dow, co-founder of Dow Jones & Company and co-founder and editor of the Wall Street Journal (WSJ), and Edward Jones, the WSJ’s other co-founder. It is an index that has gone through 57 different revisions since it was created, and to this day is supposed to encapsulate the overall state of the stock market in a single number.
The composition of the Dow right now is determined by the Index Committee, and is designed to change as the economy changes over time. Initially comprised of 12 of the biggest and most influential companies of the day, the Dow history includes an expansion to 20 companies in 1916; by 1928, it included 30 companies, which continues to be the number tracked today. Any current member of the Dow can be dropped by the Committee if the company is deemed to be less relevant to current economic trends, to be replaced by a new company that the Committee determines to better reflect said trends. The 30 companies that currently comprise the DJIA index, and the year they were added, are as follows:
As the U.S. economy has grown over time, so has the value of the Dow. Below is a graph from FRED (Federal Reserve Economic Data) reflecting how the DJIA has almost tripledover just the past ten years, growing from 12,741.02 on 1/12/2012, to 36,252.02 on 1/11/2022:
Albeit with regular speed-bumps along the way, the continued and sustained growth of the Dow has been pretty amazing!
Interested in learning more? Click the thumbnail below for a straightforward YouTube video from PBS that discusses everything to do with the Dow right now:
However, for all of its “glory” and history as the best-known and perhaps most widely followed stock market index in the world, is the Dow right now really all it’s cracked up to be? At Towerpoint Wealth, we argue the answer is no, as the index is as flawed today as when it was first calculated on May 26, 1896. The various “warts” of the Dow give us pause, and cause us to discourage our clients from considering it a truly useful proxy and viable resource to rely on.
Here are four specific reasons why we disavow the Dow right now:
1. It is narrow – “only” 30 companies are represented in the index.
Because (in theory) the 30 companies that comprise the Dow Jones Industrial Average (DJIA) index are the largest and most influential in the country, they represent only about 25% of the value of the entire U.S. stock market. However, many experts (ourselves included) feel that because it consists of only 30 large capitalization (“large cap”) U.S. companies, and neglects mid cap and small cap companies, the DJIA index does not properly represent the comprehensive state of the U.S. economy.
2. The Dow is a price-weighted index
An index that is price-weighted means that higher-priced stocks have greater weight and influence on the index compared to lower-priced stocks. On the surface this may seem logical, but the problem is that a higher-priced stock has zero correlation with a higher-value company. Put differently, a $9 stock could have a higher value than a $50 stock, but because the Dow is price-weighted, that doesn’t matter.
In a price-weighted index, a stock that increases from $90 to $100 (an 11% increase) will have the same effect on the value of the overall index as a stock that increases from $10 to $20 (a 100% increase), even though the percentage move for the lower priced stock is far greater than that of the higher-priced stock.
Put differently, a percentage change up or down in the Dow doesn’t necessarily mean that the entire market has gone up or down, or even that the Dow’s 30 companies have collectively gone up or down. The higher-priced stocks contained in the index simply exert a much greater influence on its overall direction and movement.
A prime example of why the price-weighted indexing method doesn’t make logical sense is when an index component undergoes a stock split. Prior to splitting 4-for-1 in August of 2020, Apple was the highest weighted position in the Dow at 11%, but once its stock split, it immediately had much less influence on the Dow, as it dropped to the 18th highest weighted stock in the index. While a stock split obviously does not have any influence nor change the underlying value of a company (it just lowers the share price and increases the amount of shares outstanding), it does change the influence a company has within the price-weighted index it is part of.
3. The Index Committee has only five members, and uses a vague methodology for including a stock in the Dow
Discretion is an integral part of how indices are constituted, and the Dow is certainly no exception. Unlike the S&P 500, which has a long list of eligibility requirements that some big companies can’t meet, the Dow does not have hard-and-fast rules regarding how a stock gains entry to the index. It is not governed by quantitative rules, with S&P Global subjectively stating that “A stock is typically added only if the company has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors.”
Additionally, on the Dow’s Committee there are only two representatives from the Wall Street Journal and three from S&P Global. Given the cozy size of the Committee, the subjective nature of how the index is constructed, and the sheer size and financial importance of the Dow, any decisions to include or remove companies from the index impact trillions of dollars of investor funds, not to mention the potential retention of institutional investor clients by S&P Global. This can create conflicts of interest, or even opportunities for illegal activity and fraud. Don’t believe us? In September of 2020, James Yang, a member of the Index Committee, was charged with being part of an insider trading scheme leading to more than $900,000 in profits.
4. The Dow right now does not contain some of the largest and most dominant companies in the U.S. economy
Even though they represent well what has become the most dominant sector of the U.S. economy, three of the largest and most influential technology “titans” – Alphabet (formerly Google), Amazon, and Meta Platforms (formerly Facebook), are not part of the Dow. Why? See #2 above – their share prices are too high. While there is nothing fundamentally wrong with these companies, because of the Dow’s price weightings, they won’t be included in the index because they would swamp it due to their high share prices.
The only way the Dow would ever be able to accommodate any of these three stocks is if they went through a stock split, which makes zero sense, as does excluding companies from the Dow who clearly are excellent representatives of the overall United States economy just because their stock prices are too high.
The Dow has been around for 125 years, is not going anywhere, and continues to clearly be in the mind’s eye of investors. However, the four reasons listed above support our belief that it does not accurately represent the market, and just because the Dow right now is an old, familiar, and oft-quoted figure does not make it accurate, and it should not be used as a proxy for investors to gauge the health of our economy or to measure the progress (or lack thereof) of the stock market.
What’s Happening at TPW?
A big thank you and shout-out to two excellent Towerpoint Wealth clients, David Junod and Pauline Lhote, for the very generous and thoughtful sparkling wine holiday gift fromDomaine Chandon!
Now we just have to find an excuse to actually pop a bottle or two and enjoy, rather than just pretending! Cheers!
Just last week, our President, Joseph Eschleman, CIMA®, earned his Certificate in Blockchain and Digital Assets (CBDA) from the Digital Assets Council of Financial Professionals.
The CBDA course is the only cryptocurrency certificate program designed specifically for financial professionals. Graduates of the program have gained the essential knowledge and understanding of blockchain and digital assets, better equipping them to provide investors the expertise and advice they need about this new and transformational asset class.
TPW Taxes – 2022
2022 will assuredly be a different year than 2021, with income taxes no exception. Click the image below to access the 2022 Quick Tax Reference Guide, a practical resource providing a plethora of consolidated and easy-to-understand information to help you make sense of the complex and ever-evolving array of U.S. federal tax rules.
At Towerpoint Wealth, we recognize that income taxes are a “necessary evil” when helping you build and protect your wealth and net worth, but fortunately they can be planned for, managed, and oftentimes minimized!
Click HERE to read more about our “tax sensitivity” and philosophy towards reducing your obligation to Uncle Sam.
TPW News You Can Use
Useful and interesting content we read the past two weeks:
- Desperate No-Vaxxers Paying COVID-Positive People $150 for Dinner and COVID Infection – The Daily Beast – 1.12.2022
A new vaccination mandate in Italy requires everyone over 50 to be vaccinated or pay a hefty fine. Some are opting to pay to get infected with COVID instead.
- The 2022 NFL Playoffs – Everything You Need to Know – com – 1.9.2022
AFC, NFC, and Super Bowl 2022 schedule. Seedings. TV times, dates, locations. Find everything you need to know about the NFL playoffs here.
- Hillary 2024? Don’t Rule It Out – The New York Post – 1.12.2022
Could a third time be the charm for Hillary Clinton? That’s the case made by two prominent Democrats who claim a “perfect storm” of President Biden’s plummeting job approval ratings, Vice President Kamala Harris’ own unpopularity, and the commander-in-chief’s advanced age could provide an opening for the former first lady and secretary of state.
Chart/ Infographic of the Week
After a 26.9% gain for the S&P 500 in 2021, many investors are hopeful that 2022 is another strong year for the markets. And while consistently and accurately predicting the future is next to impossible, the chart below from Morningstar gives hope to what the future may have in store for the market this year:
Quote of the Week
Staying positive and keeping a good attitude is key!
As the 24/7 news cycle churns, twists, and turns, a number of trending and notable events have occurred over the past few weeks:
- Microsoft hit by defections as employees move to Facebook parent Meta
- Inflation reaches its highest level since 1982 as consumer prices surge 7.0% over the past year
- San Francisco mayor London Breed announces no new restrictions, says that “we are learning to live with COVID”
- Russia has amassed 100,000 combat-ready troops, tanks, and other military equipment by Ukraine, and NATO is doing what it can to ease tensions
- Rachel Balkovec to be the first woman ever to manage a team affiliated with Major League Baseball
- Oakland students threaten to boycott classes unless school district meets COVID demands
- Sidney Poitier dies at home at the age of 94
- Analysts speculate that oil prices could hit $100 as demand outstrips supply
As always, we sincerely value our relationships and partnerships with each of you, as well as your trust and confidence in us here at Towerpoint Wealth. We encourage you to reach out to us at any time (916-405-9140, firstname.lastname@example.org) with any questions, concerns, or needs you may have. The world continues to be an extremely unsettled and complicated place, and we are here to help you properly plan for and make sense of it.
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