Growing Irrelevance of Dow Jones Industrial Average–DJIA: Antiquated, Arbitrary, Poor Measure of Overall Economy, Business…

Dow Jones Industrial Average -DJIA- is perhaps the most widely followed stock market index in the world. Yet, very few people actually know what the number represents.

Dow Jones Industrial Average -DJIA or Dow- is the world’s most famous stock market index; but according to ‘mymoneyblog’, it’s an antiquated, somewhat-arbitrary, poorly constructed, incomplete indicator that does a sub-par job of tracking actual performance of the stock market, or anything else for that matter: Every time the financial media quotes the Dow Jones Industrial Index (DJIA), down to the last decimal points, like it’s some hyper-accurate holy number, it’s very annoying. 

The DJIA was first developed by Charles H. Dow in 1896 with the selection of 12 stocks. In 1916, it grew to 20. In 1928, it increased again to 30. It’s still just 30 stocks over 80 years later. Not only that, but it’s not even clearly defined as the largest 30 companies. It’s simply 30 companies chosen by a committee to best represent the market (i.e., in their opinion) out of the ~5,800 publicly traded companies.

The DJIA is price-weighted, but it– does not weigh its 30 component companies based on their market capitalization (i.e., total market values) like other indexes (e.g., S&P 500, NASDAQ, etc.), but rather, it’s based on the ‘share price’ of the component companies. This flawed calculation creates an extreme variant weighing for similar companies, e.g. compare the weighing of DJIA components– IBM vs. GE, where IBM ($107 billion revenues, in 2011) has a huge 12% weighing, on the index, while GE has barely a 1% weighing, despite having near $150 billion in sales.

The ‘Industrial’ portion of DJIA is largely historical, as most of the modern 30 components have little or nothing to do with traditional heavy industry. The value of the DJIA is not– actual average of the prices of its components, but rather it’s– sum of the component stock prices– divided by a ‘divisor’, which changes whenever one of the component stocks has a stock split or stock dividend; this is done to generate a consistent value for the index.

Although Charles Dow compiled the index to gauge performance of the industrial sector within the U.S. economy; today, the DJIA is influenced by not only corporation and economic reports, but also by domestic and foreign political events, such as; war, terrorism, natural disasters… any event that could potentially lead to economic harm…

In the article Never Say Dow by Kenneth L. Fisher writes: Dow Jones Industrial Average (DJIA) is completely useless, misleading index of market performance, and ineffectual for analyzing history or making forecasts. There are two reasons: First, an index of 30 stocks is necessarily a narrow and arbitrary gauge of market activity. Second, it has a structural deficiency– it’s price-weighted. That is, you add up the prices of the 30 stocks, than divide by an adjusting factor to get the index value.

When Charles Dow first calculated his index, he divided by the number of stocks he was tracking to get an average stock price. Over the years he and his successors had to adjust the divisor to preserve continuity in the index as component stock’s price split and some stocks were replaced. What’s wrong with a price-weighted index? In the weighting of the components it ignores the variations in the market values of the different component companies.

Instead, it gives most weight to companies whose share prices happen to be high. For example, a company with a share price of $100 would have twice the weight of a company with a share price of $50. With price weighting there is the absurd result that the performance of the DJIA hinges on what stocks split and when; for example, if IBM splits 2-for-1, its weighting in the DJIA is cut in half.

This is absurd, because stock splits are purely cosmetic; they have no bearing on any investor’s net worth or dividends. DJIA is completely ineffectual for analyzing market history. Mathematically, yearly outcomes are purely random depending on which stocks split and when… similarly for making forecasts…

In the article Shake Up Dow! by Andrew Bary writes: The Dow Jones Industrial Average (DJIA) is overdue for makeover. The world’s most famous stock index hasn’t adjusted component companies since 2009, during which time Apple has emerged as one of the world’s most valuable company… and Google; both companies are conspicuously absence from DJIA.

These companies represent major shifts in the global business landscape, yet admitting Apple or Google — or any other high-priced stock — would be difficult, given how DJIA is calculated. Since DJIA weights its component companies based on absolute stock share price: Apple’s price of around $600, would overwhelm the index with a 26% weighting, which is double the influence of current DJIA component…

Given its daily swings, Apple alone could move the DJIA regularly by 100 points… One solution would be to adjust DJIA calculations; capping weighting of stock at fixed percentage… However, changing the DJIA’s format won’t be easy, which may be why an Apple-friendly alteration hasn’t happened, yet. The reality, however, is that the DJIA amounts to a $20- or $25-stock average now, because the lowest-priced stocks matter little. Some agree with John Prestbo; not worth tampering with DJIA just to include; Apple, Google…

According to Jeff Rubin, DJIA is still a relevant and important indicator that tracks the market closely… It’s what individual investor focus on. However, Rubin questions whether lowest priced stocks need to be in the index at all, because they have so little impact. He points out that the correlation of DJIA with the S&P 500 is more than 90%. This means these two indexes tend to move together, although not in lockstep. Even with the quirks and archaic calculation method, the DJIA remains the most widely followed market index…

In the article Why Do We Still Care About the Dow? by Adam Davidson writes:  The DJIA remains not only a rough measure of stock market performance, but also the most frequently checked and cited, proxy of U.S. economic health. In the postwar boom of the 1950s, the economy was growing so fast, and the benefits were so widely shared, that following 30 large U.S. companies was a solid measure of most everyone’s personal economy.

Back then, the U.S. was largely self-sufficient country, so Asian or European economic troubles didn’t matter much. There was less national inequality, and everyone’s income tended to move in the same direction. By late 1990s, however, the DJIA stopped being an indicator of how the U.S. economy was doing; instead, it became a driving force. During the frothing of tech bubble, the hottest companies weren’t making money by selling profitable products and services, in the real world– they were selling fantasies to stock investors.

The DJIA, drawn out to two decimal places, may seem like the perfect scientific number, but it’s far from it. A small committee selects 30 big companies and then adds up the price of their stocks. Then, analysts divide by the Dow divisor, a mis-leadingly precise-seeming number formulated to account for things like; dividends and splits. These are the least of the Dow’s problems: More troubling is that it ignores the overall size of companies, and only pays attention to share prices.

Yet the DJIA’s biggest flaw, perhaps, is that it doesn’t help us to make sense of an increasingly interconnected global economy– one in which companies, such as; GE, IBM, Intel… all make more than half their profits in other countries. But still, some argue that the stock market reflects the overall wisdom of the world’s investors. That may be true when looked at over months or years, but it’s never very clear what wisdom is telling us at any given moment: Panic in Europe might have investors terrified about the next few months, sending stock prices down, but that downward move could be obscuring the fact that those same investors feel chipper about the economy 2 or 10 years down the road.

Alternately, investors might feel very bad about the long-term future of U.S. economy, but are excited because, for example; that afternoon the Fed announced a low-interest-rate policy. None of these criticisms is news to finance professionals, most of who use far more precise measures– like the S&P 500 or the Wilshire 5,000, which cover more companies more precisely– when making investing decisions. In fact, that might not even surprise Charles Dow, who created the DJIA. It’s interesting, Charles Dow, himself, infrequently observed his own index, says John Prestbo.

Also, Prestbo caution the average investors against drawing broad conclusions about the overall health of the economy from any narrowly focused stock average. This is particularly true, now; for the first time in a while, the economy is truly worth worrying about. It’s even more true when a twitchy financial system is being monitored by a twitchy index that’s perfectly suited to 24-hour news cycle.

The DJIA is simply an obsolete mathematical calculation-created and relatively unchanged since 1898-tracking only 30 companies selected by Dow Jones’ management. According to Yaron Ron Reuven, Dow Jones management claims that modifying DJIA calculation methodology poses the risk of destroying one of its distinctive qualities.

Further, they claim that despite the limited number of stocks in the DJIA, it has had more than a 90% correlation to the widely diversified S&P 500. According to ‘Weakonomist’, DJIA remains important for two reasons. The first is because it’s old and most people are traditional idiots and love old things, despite its relevance. The other reason is because the 30 stocks represent U.S. brands. If these companies fail, we’re all screwed we think– not so fast ‘pessimistic Patty’.

The backbone of this country is ‘small’ business; these are—‘mom and pop’ shops, local gas station, local company that employs 1,000 people or less. That’s what actually runs the U.S. and, as such, the U.S. economic health cannot be measured by one metric. If you want to measure the status of big companies, use the S&P 500, which includes the DJIA and all of their competitors.

If you want to measure the health of the stock market, follow the Wilshire 5000, which includes (you guessed it) 5000 stocks. Throw in your quarterly GDP date, price of oil, and the greenback vs. euro numbers and you can actually get a much better idea of the economy…

How’d the ‘market’ (DJIA) do today? You hear it on street corners, you see it in office restroom stalls; folks trading well-known information, fiction, fact, hype, hyperbole; they share their wisdom on the ways of the ‘market’…