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Why Do We Trust the DOW?
Topic Started: 28 Oct 2009, 05:21 PM (1,006 Views)
Ryan
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[Taken from my blog.]

Economists and cable TV commentators are incessantly pointing to the latest numbers from the Dow Jones Industrial Average (DJIA, or simply, the “Dow”) as an indicator of “how the economy is doing.” Every time the President, Treasury Secretary, or Fed Chairman speaks, everyone rushes to check the “reaction” in “the market,” measuring political success by the Dow spiking and failure with it sinking.

Why? It makes absolutely no sense. Many people don’t know what the Dow Jones even is, perhaps they see it simply as some magical indicator of economic growth. The problems of measuring economic growth accurately aside, let’s examine why the Dow Jones fails as an economic indicator and see how we might as well arbitrarily choose another “formula” to base our lives around.

So what is the Dow? The Dow Jones Industrial Average is a stock market index, owned by Dow Jones & Company and run by the Wall Street Journal, which measures the stock prices of the 30 largest “industrial” corporations in the U.S. Currently the companies on the Dow are:
1. 3M
2. Alcoa
3. American Express
4. AT&T
5. Bank of America
6. Boeing
7. Caterpillar
8. Chevron Corporation
9. Cisco Systems
10. Coca-Cola
11. DuPont
12. ExxonMobil
13. General Electric
14. Hewlett-Packard
15. The Home Depot
16. Intel
17. IBM
18. Johnson & Johnson
19. JPMorgan Chase
20. Kraft Foods
21. McDonald’s
22. Merck
23. Microsoft
24. Pfizer
25. Proctor & Gamble
26. Travelers
27. United Technologies Corporation
28. Verizon Communications
29. Wal-Mart
30. Walt Disney
To measure the Dow is simple, simply add up all the stock prices of each of the above 30 companies, and divide by what is known as the “Dow Divisor,” a mystical number which changes to take into account any changes in stock issuance, dividend payments, and changes in the major corporations. So a stock trading at $100/share will count 10x more than a stock trading at $10/share. It’s not a market weighted index, which intuitively would simply be the product of the price of a corporation’s stock times the number of shares outstanding. The index is price-weighted, which means that it is determined by weighing each corporation’s stock according to its price.

Shortcomings
Alright, now that we know what it is, what’s wrong with this overused index?

  • Number of Firms. The Dow Jones measures only 30 companies. Granted, these are some of the most massive and wealthy corporations in the country (and the world), but the U.S. economy is comprised of more than simply 30 companies, even more than 3,000,000 companies. Many people may object that the large companies are the ones that matter because they generate the most work and are the most productive. While they are no doubt important, it is small business that is the lifeblood of the economy. According to the Small Business Administration, small firms represent 99.7% of the economy, employ over half of the entire U.S. (private sector) labor force, and pay 44% of U.S. private sector payroll.[1] It is small business that generate jobs.
  • Corporate Changes. The Dow Jones compromises 30 companies, no more, no less (though it started off with only 12). What about those corporations that are right “on the margin,” – the 31st firm certainly has a (however slightly) notable impact on the stock market. The Dow has also changed to include certain companies and exclude others over the years.
  • Industrial? While industry and manufacturing is certainly a critical part of all economies since it generates production and real wealth, the U.S. economy is post-industrial. The U.S. economy has shifted from a manufacturing to a service-based economy. Even more fundamental than what types of products we produce, the U.S. no longer is a producer country, we only consume – we borrow money we don’t have for things we don’t need, go into debt, and then we consume all the products from the countries that still produce, like China. So why are we using the Dow Jones, a measure of industrial activity to gauge the entire activity of the economy? Under the popular trend of thinking (which is by no means correct economically), why don’t we measure the size of the national debt and federal deficits and praise them when they increase and boo them when they decrease? At least that would do more justice by accurately representing the ginormous proportion that our debt economy has swelled to.
  • Stock Market. The Dow Jones is an index which measures the stock/equities market. Despite all the hype and bustle always seen on the news and associated with Wall Street, the stock market is NOT the major source for financial activity. The stock market is a tool for only the largest public corporations approved by the government to sell common and preferred stock to raise enormous amounts of capital. The true hub of financial activity is the bond market - where the government and corporations under less restrictive regulation write I.O.U.s in exchange for quick cash from investors. And virtually all small businesses are financially dependent upon bank loans, since they do not meet the stringent legal requirements to enter the bond or stock market. The (secondary) stock market simply gets a disproportionate amount of coverage in the media – perhaps because it is so dramatic on a day-to-day level and involves major corporations that have instant name-recognition and loyal customer bases. Measuring the stock market to gauge the economy (let alone a mere 30 companies on the stock market) makes about as much sense as measuring the length of your index finger to determine how tall you are.
  • Price Weighted. The Dow is a price-weighted index, so changes in corporations’ stock prices within the Dow have different effects on the overall score. If IBM is trading stock at $100 per share and Bank of America is trading stock at $10 a share, IBM’s stock will have 10x more of an effect on the Dow. If IBM’s stock price goes up $1, the Dow may jolt upwards, whereas if Bank of America’s stock price goes up $1, the Dow might only hiccup unless it were to increase $10 (on par with IBM). Thus, certain companies are strongly represented and others have a weak effect – for example IBM and Chevron have the highest influence due to their high share price, while Alcoa and Pfizer have the weakest. In an extreme example, if Alcoa were to completely go bankrupt but Chevron were to triple its returns, the Dow might not even move. There’s obviously something wrong with that.
  • Inflation. So why is the Dow so high? Compare the Dow Jones of 1970 and that of 2000. [2]
    Posted Image
    The 1970 Dow was around 1,000, whereas the 2000 Dow was around 10,000. That’s a tenfold growth factor in about 1/4 of a century. Granted, there has certainly been economic growth since the 1970s, but 10x sounds a little fishy. But bear in mind that all stocks are quoted in U.S. Dollars. Compare the Purchasing Power of the U.S. Dollar from 1900 to 2000. [3]

    Posted Image
    According to the government’s own Consumer Price Index, the dollar in 1913 was worth $21.80 of today’s (2009) money. It’s a shame how rampant inflation over the 20th Century, caused by the Fed, have made it look like an enormous increase in the Dow was a secular trend of genuine growth. Instead, share prices are inflated and it is very difficult to compare genuine growth with inflated prices. What would the Dow be today in 1913 levels? With a present Dow hovering around 10,000, the Dow would be 458.72. Let’s take it one step further and measure the Dow relative to an asset that has maintained a stable real price for milennia – gold. Dividing the Dow from 1900 to 2009 based on the average price of gold each year, we arrive at the following chart. [4]

    Posted Image
    Sorta puts a damper on that whole super tenfold economic growth idea huh? Misleading information and statistics easily hide these false trends from the public eye.


Conclusions
Is the Dow Jones inherently misleading and barren of all usefulness? Of course not. It is rather useful for a “first glance” measure of how the stock market is doing if you are an equity investor. The true problem lies in the fact that is misapplied to speak for the economy as a whole. It provides a relevant and roughly accurate measure of a very small segment of the economy, a larger but smaller segment of the financial market, and a good chunk of the stock/equities market.

Is there anything that can replace the Dow? Well, that would be a great subject for another debate, as to what (if any) indexes, formulas, or statistics would provide a better glimpse at economy activity as a whole. But if you’re looking for the by-all end-all formula to gauge economy activity, and “what the market thinks” of a political action or economic policy, you might as well use E=mc². Or better yet, use your own common sense and ask “how will this help or hurt me?” and then consider life from other people’s perspectives. The Dow isn’t going to do that for you.

NOTES:
—————

[1] Small Business Administration – Office of Advocacy. Frequently Asked Questions <http://www.sba.gov/advo/stats/sbfaq.pdf>

[2]<http://www.visualizingeconomics.com/wp-content/uploads/DJIA_History.png>

[3] <http://statesmen.blogspot.com/2008/01/purchasing-power-2008-vs-1970.html>

[4] Prepared from Yahoo Finance historical DJIA values at the end of each December divided by the goldprice.org gold prices at the end of each year.

http://ryansafner.com/2009/09/29/why-do-we-trust-the-dow/[/list]
Edited by Ryan, 28 Oct 2009, 05:22 PM.
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Lundymaphone
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Well I can't really think of any one index that is a better indicator for economic health, but I think the real question is, who are these people that you are talking about that trust the dow?
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Ryan
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Well, perhaps it is different in Canada so you don't notice, but at least in the U.S. every news personality and commentator (whether a general anchor or a "specialist") always refers sacredly to the Dow, and only the Dow.
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Lundymaphone
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In Canada we usually comment on the Dow, NASDAQ, European Markets, Asia and the TSX (Toronto Stock Exchange). But when it comes to economic recovery we tend to focus on the GDP and Job situation.
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Ryan
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I'm not saying that UE and GDP are unimportant or never referred to, but both experts and commoners alike equate a rise/fall in the Dow with the state of "the market" and our recovery.
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Lundymaphone
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Don't worry Ryan I probably get more American News channels then you do (I am not actually kidding, I have about 12 distinct American channels (not including the 5 different Fox's or 4 Different NBC's)). I understand how it works down south, just telling you what it is like up here.
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Michael Irick
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Wow, Cat is ranked higher than Microsoft?
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Ryan
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No, they're just listed alphabetically. :lol:
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kevin jackson
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The dow is a very resilient index, despite the uncertainties in the market and the economy as a whole, it overcame it all and is still walking through it all...
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