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| Why Do We Trust the DOW? | |
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| Tweet Topic Started: 28 Oct 2009, 05:21 PM (1,006 Views) | |
| Ryan | 28 Oct 2009, 05:21 PM Post #1 |
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Intellectual
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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?
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 | 28 Oct 2009, 09:43 PM Post #2 |
Intellectual
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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 | 28 Oct 2009, 09:52 PM Post #3 |
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Intellectual
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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 | 28 Oct 2009, 09:57 PM Post #4 |
Intellectual
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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 | 28 Oct 2009, 10:02 PM Post #5 |
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Intellectual
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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 | 29 Oct 2009, 01:45 AM Post #6 |
Intellectual
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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 | 30 Oct 2009, 07:44 AM Post #7 |
Follower
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Wow, Cat is ranked higher than Microsoft? |
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| Ryan | 30 Oct 2009, 06:16 PM Post #8 |
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Intellectual
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No, they're just listed alphabetically.
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| kevin jackson | 24 Aug 2010, 10:30 AM Post #9 |
Apathetic
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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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