I read a fascinating set of articles around the time GE was being dropped from the Dow. You know, the Dow Jones Industrial “Average.” The thing that Every News Outlet Ever uses to tell if the economy is tanking, although oddly they never rely on it to tell you the economy isn’t tanking. The “Average” that can drop 300 points and cause massive panic, yet gain 400 points without comment.
Let’s think about what most people think the DJIA is supposed to be doing. It’s supposed to be a broad indicator of the health of the American economy. Now, the American economy has shifted a lot over the past 100 years, which is why companies do come and go from any index like the DJIA. In the early 1900s, you might have expected the Dow to include companies like Standard Oil, AT&T, and GE… and it did.
Now, of course, you might expect it to include some of America’s more modern powerhouses, like Apple, Microsoft, Amazon, or Google.
Only kinda. Apple and Microsoft are in there, and they’re meant (along with Cisco and Intel) to represent the entire tech industry within the DJIA. Why not Amazon or Google?
You see, the Dow is a price-weighted index. When you say “the Dow is at 20,000,” you’re not saying it’s “trading for $20,000,” because you don’t trade in the Dow, and its number doesn’t represent dollars. Of the massive list of stocks in the Dow (actually it’s only 30), the index’s numeric rating is more heavily driven by the more expensive ones, and less driven by the cheaper ones. Chuck a stock like Amazon in there, which is basically trading at seventeen purpillion per share, and the Dow’s number would be driven entirely by that one stock. The other 29 wouldn’t even matter. And so the Dow can’t include many of the actual economic powerhouses of our modern economy. Instead, it includes companies like Walgreens, supposedly to “represent” health care. Why Walgreens and not CSV, or AstraZeneca, or someone else? They all cost too much. They’d mess up the “average.” You do get Johnson & Johnson, Merck, Pfizer, and United Health, though, which weights the Dow very heavily toward healthcare already.
So, you have an “average” that’s supposed to represent an entire economy using just 30 stocks, but can only include stocks within a certain price range, and that – despite what the word “average” means in math – doesn’t actually “average” those stocks’ prices. Frankly, anytime anyone in the media even mentions the DJIA, someone should punch them in the face.
Trading on indexes is fine, so long as you understand what they represent. The S&P 500, for example, is a pretty decedent indicator of large-cap stocks. It doesn’t seek to represent the entire market, only a portion of it, although in many ways the large-cap stocks do drive more market volume. And with 500 stocks in the index, it’s easier for it to represent an average of that market slice. There are plenty of other indexes that each seek to represent their own slice of the market. None of them are the Dow. You’ve got the Russell 2000, the Nasdaq Composite, and many more. Follow several of them and you’ll get a good general sense of what the overall market is going (which does not represent what the economy is doing, as the market is fully capable of moving opposite the general economy sometimes). Bear in mind that many of them are also price-weighted, though – they’re not an average, although to be fair none of the other ones claim to be right in their name.
The Dow likely made sens in the early 1900s, when it contained just 12 stocks, because the American economy was kind of brand-new to the whole publicly traded company thing. Twelve was a good average when the entire market had, like, 20 companies.
- American Express
- Walt Disney
- Goldman Sachs
- Home Depot
- JPMorgan Chase
- Procter & Gamble
- Travelers Companies
- United Technologies
Senior guys in the Dow these days are P&G, who’s been in since 1932, and ExxonMobile, who’s been in since 1928.
To be fair, the Dow does touch on what most people consider to be the major verticals in the American economy: Manufacturing, Technology, Energy, Health, and Finance. You’ve got some retail, you get a proxy for agriculture (in Caterpillar), and you’ve got a bit of fast food. A smidge of entertainment. But if Apple – one of the pricier stocks in the DJIA – takes a hit, the entire DJIA takes a big hit, even if (for example) every other segment is doing gangbusters. There are just too few stocks being used to represent far too broad an economy. Where’s transportation, for example? No UPS or FedEx? Retail is deeply underrepresented, given it’s where most Americans spend most of their discretionary income. Insurance isn’t well-represented, although it’s where much of the country’s investment assets end up. Real estate – a prime mover of economic growth, and a frequent proxy for overall economic health – isn’t in there at all. Other than Boeing, none of the Dow companies focus on defense contracting, another major economic proxy.
Anyway. Next time someone crows about the Dow tanking, just have a cocktail and look at the many other indexes. If they’re all tanking, then sure, worry a bit if you’re a short-term investor. Otherwise, have another cocktail.