This morning’s pre-markets showed a wild divergence: the S&P 500 Futures were on a gentle climb upward, while the Dow Jones Futures were indicating as much as a -200 point loss. The cause of the divergence was obvious to long-time market participants – Boeing (BA) shares were trading 10% lower, and it has a disproportionately high weighting in the price-weighted Dow.
Simply put, the Dow Jones Industrial Average (INDU) is a relic. I have held his opinion for years, and I know that I am not alone. I once asked a producer at a major financial network why they kept featuring the Dow in their market updates, and he replied essentially that they needed to do so because viewers expected it of them, even though most professionals knew it was obsolete.
A bit of history is appropriate here. In 1885, Charles Dow, editor of the Wall Street Journal, and one of his associates, Edward Jones, created the first stock market index. It was a worthy endeavor, as there previously was no accurate way to measure the stock market’s performance as a whole. The methodology was appropriate for the computational technology available at the time – a pencil and paper. They took an arithmetic average of the original 14 components and reported it to their readers. That original index was primarily railroad companies (the hot, growth sector of that era), and in 1896 they created the 12 stock Industrial Index. Over the ensuing decades, the 12 components became 30, and the divisor was adjusted as splits and composition changes occurred.
Yet the index’s main deficiencies remain. For starters, 30 stocks are too few to properly measure the aristocracy of the US equity markets, let alone the markets as a whole. Also, price weighting has proven to be a very poor index methodology. A stock’s price may bear little value to its value. A company with a highly priced stock and a small float may be worth less than one with more outstanding shares at a lower price. That adds an unnecessary element of randomness to a price weighted average. Should a $400 Boeing be 10 times more important than a $40 Pfizer (PFE)? I’ll argue absolutely not! Both PFE and BA have market capitalizations of roughly $225 billion. Similar percentage moves in both have similar effects on investor wealth, yet that move in BA has 10x the effect on INDU as PFE! Both stocks have a roughly 1% weight in the S&P 500 Index (SPX), yet BA has a 10% Dow weight compared to PFE’s 1%.
Most indices rely on weightings based upon market capitalization. A predecessor company to Standard and Poors began creating market cap weighted indices, and in 1957 S&P expanded their 90-stock index to 500 components. Greater computing power allowed more complex calculations in a rapid manner, making a price weighted index an inferior relic. Investors clearly agree, at least when it comes to their own money. Vast sums are committed to the SPX index and its various sectors, while a relative pittance is directly invested in the Dow. As a result, investors should follow their wallets and care substantially more about the performance of SPX.
I have a particular animus toward the Dow. When I worked at Morgan Stanley, it was up to my team of international traders to provide a global market update to the Salesforce. We tended to think of global index moves in percentage terms, which is a rational means for comparing moves in indices that may have vastly disparate price levels. Yet some of the older sales traders required us to report global index moves not only in percentage terms, but in Dow points. (This morning the DAX is up 71 points, or .62%, or 158 Dow points.) I loathed that requirement as archaic and silly, but they were Managing Directors and I wasn’t.
The market’s dinosaurs have long since retired. Yet the biggest Brontosaurus of them all, the Dow Jones Industrial Average, still roams the financial markets. Please, for the good of the investing public, can we retire that one as well?
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