Since mid-December, various media outlets have been frantically tracking the Dow Jones as it approaches the 20,000 mark for the first time. But what does hitting 20K really mean for the index, and the market as a whole?
Over the last month or so, the financial media has been enthralled in a collective mania over one number – 20,000.
That’s because the Dow Jones Industrial Average, the second oldest stock market index in the world, has been hovering around that marker for a while now, and it seems like all other news must take a backseat until that number is hit.
When it comes to the financial world, numerical milestones are pretty facetious. Will the world really be in much better shape when the Dow hits 20,000 points than when it hit 19,999.63 earlier this month?
Of course not. But in the base-10 numeral system we operate in, those pretty round numbers are always going to attract attention.
The real problem is with the Dow Jones Industrial Average itself, which, as I hope you’ll agree after reading this, is a completely useless measure of just about everything.
Let’s start with some history about the Dow.
The History of the Dow Jones
The Dow Jones Industrial Average was created by Charles Dow, the one-time editor of the Wall Street Journal, in 1886. Its purpose was to get a view of how the largest industrial businesses in the United States performed in a single trading session. It was the second stock market index ever created, after the Dow Jones Transportation Average (also created by Charles Dow).
Originally, the index had 12 companies – the only one of which remains is General Electric. Without computing power, the index was calculated the simplest way possible – by taking the stock price of all the components and adding them up.
In the early days, the index was largely ignored – even by its creator. However, with the panic of 1907 (where US stocks fell by 50%), it became as useful a measure as any for how the stock market was recovering.
Since then, the Dow Jones Industrial Average has become one of the most followed stock indexes in the world – frequently cited on the evening news, and often closely watched in the wake of geopolitical events, terrorist attacks, or stock market crashes. In general, it is reported as a good measure of how the economy is performing.
But the problem with the Dow is that it doesn’t even give us a good measure of the stock market, let alone the whole economy.
How the Dow Jones is Calculated
Firstly, the Dow Jones only focuses on 30 companies (up from the original 12). Back when it was first developed 120 years ago, 12 companies was a pretty good representation of the market in general. However, there are over 7000 companies on the US stock exchanges today. So with the Dow Jones, you’re only talking about less than 0.5% of the whole market.
There’s an easy way to fix that – just focus on the biggest companies. That way, you’ll at least get a good sense how the big players are performing. But even though the 30 components of the Dow are all large companies, they are not the biggest by any means.
The biggest company in the world – Apple – is in there, but number two Alphabet is not. Nor are the likes of Facebook, Berkshire Hathaway, Wells Fargo, or Amazon (which you could argue is perhaps the most important company operating today).
Instead, the Dow comprises of a mish-mash of some of the biggest businesses from some of the sectors. But not all the sectors.
Though they gave up on only tracking “industrials” a long time ago, they still don’t include companies from the transportation or utilities sector, as Dow has always had separate indexes for these.
Basically, it’s a lucky dip of companies, chosen for vague and imperceptive reasons, that are somehow supposed to give us a good overview of the stock market.
But it gets worse…
Unlike almost every other index in the world, the Dow Jones Industrial Average is a price-weighted index.
Bear with us while we try to explain how ridiculous that is.
Imagine you’re trying to figure out how a stock market comprised of 30 companies was performing. It would be sensible to include all those companies, but considering each of them was a different size, you couldn’t give them all the same importance. After all, a company that is worth $200 billion is going have have a bigger impact on the market than a company that is worth $20 billion. Most logical people would approach this problem the same way and say “Okay, we’ll make the $200 billion company 10 times as influential as the $20 billion company to come to a meaningful average”.
This is how most indices, including the S&P 500, do it.
However, the Dow Jones doesn’t put any weight into the actual size of the companies they follow. Instead, they focus on the price of an individual stock, and use that as the factor when deciding how much weight each company has.
Since a stock’s price says nothing about the actual value of the company, this leads to some very odd situations.
Rather than Apple (the largest public company) having the most influence, Goldman Sachs – the 48th largest company – does. This is because Goldman Sachs shares trade for about $230 a share, while Apple trades for $120. So even though Apple is more than six times bigger, Goldman Sachs is given almost twice as much power when it comes to calculating the average.
It gets even crazier when you look at companies with very low stock prices.
General Electric is almost three times as big as Goldman, but with a stock price of $30, it only has about an eighth of the influence. Worse still, General Electric only has about a quarter of the influence that the Travellers does, even though it’s nine times bigger.
So you’re left with a scenario that even if the stock market is having a very bad day, the Dow could be up because a few companies with higher weightings are holding it up – for no other reason than their stock price is bigger.
This often leads to days where the Dow Jones and the S&P 500 (which is a much more accurate measure of the stock market), could be going in completely opposite directions. Yet the news media will usually refer to how the Dow has performed, ignoring the S&P 500.
So why don’t they change the way it’s calculated after all these years?
Those in charge of calculating the Dow have long stressed that to change the formula would be to lose the historical significance of the index. Basically, if we change it now, we won’t be able to compare it to figures from 120 years ago and onwards.
It’s a real case of, “Well, this is the way we’ve always done it”.
Nostalgia aside, at least now you know what’s really going on with the Dow Jones, and when it finally does cross that magic number, you’ll know the appropriate response… “So what?”
Just don’t tell this guy.
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Rubicoin operates a full disclosure policy. Rubicoin staff currently hold long positions in Apple, Google, Facebook, Berkshire Hathaway, Amazon and the S&P 500.