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Dow Jones Industrial Average Index

Written By Brian Hicks

Posted February 26, 2009

Here’s a shock for you: after a lifetime spent watching the Dow Jones Industrial Average, I’ve decided to do the unthinkable…

I’m giving up the Dow for lent.

And while I know that single act might not curry much favor with the man upstairs, I’m sure abstaining from the bellwether index will do wonders for the bags under my eyes and the nervous tic I’ve developed.

A bellwether, by the way, is loosely defined as anything that tends to create, influence, or set trends. By that measure the Dow Jones is certainly one.

The term comes from the Middle English word "bellewether" and actually has nothing to do with the "weather" as we know it. Instead it refers to the age old practice of putting a bell around the neck of a castrated ram (a wether), allowing the beast to lead its flock.

All of which seems appropriate these days as the current clang, clang, clang of the Dow leads the markets lower. As the Dow goes, in other words, so goes the rest of herd — even if it’s over the cliff.

And to think, we owe all of this madness to a financial journalist named Charles Dow, who created the bellwether index over 113 years ago. We’ve been tied to his handiwork ever since, warts and all.

How the Dow Jones Industrial Average Is Calculated

But really to understand how flawed the Dow has become, it is important to understand how the average is calculated.

That’s because the Dow has always been what’s known as a price-weighted index. In fact, originally, Charles Dow simply added up the share prices of the companies in his index and divided by their number. It was an average in every sense.

And when Charles first published his index in what would later become the Wall Street Journal, his Dow Jones Industrial Average stood at a mere 40.49 for the 12 companies in it.

But of course over time, the Dow—as it came to be known—took on a life of its own and changed radically over the years. So figuring out the average these days is slightly more complicated than the Dow’s original math.

Due to the changing nature of the companies in the index, and to compensate for dividends and stock splits, the Dow is now calculated using the "Dow Divisor." It’s done this way in order to keep the index value consistent over time.

So to figure out the Dow Jones Industrial Average on any given day or in any given moment, you need to add up the share prices of the 30 stocks in the DOW and divide by 0.125527090, the current value of the divisor. The result is the number that sends the herd in a given direction.

Price Weights Skew the Dow

But what is really important to understand about the way the Dow is calculated is this price weighting itself can wildly skew the results.

This leaves us with something of a cracked mirror, since the price movements among the eight top stocks of the DOW carry entirely too much weight.

For instance, did you know that the top eight stocks in the Dow currently make up over 50% of the average? Or that the bottom eight stocks were only responsible for a mere 6%?

But due to the way the Dow Jones Industrial Average is constructed, it is as distorted as it is true.

IBM, Exxon Mobile, Chevron, McDonald’s, Johnson & Johnson, Proctor & Gamble, Wal-Mart, and 3M account for 52% of the 7200 on the Dow, or almost 3800 of the total.

Meanwhile, all of those "problem" stocks at the bottom account for very little these days.

In fact, the share prices of Citigroup, General Motors, General Electric, and Bank of America could all go to zero tomorrow and the hit on the Dow would only be a mere 158 points.

So while all the fear in the markets has revolved around these "problem" stocks and the companies like them, the larger truth is that these stocks have already done their damage.

Conversely, if the Dow is going to take anymore big drops — say to 6500 — it will likely have to come at the expense of the stocks at the top; that is where the weight of the average is, currently. A whole eight stocks make up most of the moves.

Yet despite the obvious flaws in its current make up, people still slavishly tie their market perceptions to the Dow or, worse, tie their savings up in 401K’s that merely mimic it.

The larger question, of course, is whether or not following this castrated ram makes much sense anymore, or if it ever really did.

After all, at its best the Dow only represents the price movement of just 30 stocks in a universe of over 8000. Yet, the market tide rises and falls with that puny slice as if doing so were completely rational. I would argue that it is not.

Instead, savvy investors recognize that a falling market led lower by this bellwether gives them the opportunity to buy individual stocks at a significant discount. That’s a contrarian strategy that has paid off well for Wealth Advisory subscribers since the Dow has grabbed all of the headlines. (We are 20-2-1, picking winners since October 10th.)

So for the next 40 days I’m going cold turkey on the Dow, ignoring its noise now more than ever. Even still, this is something I will have to take one day at time. 

After all, old habits die hard.

Your bargain-hunting analyst,

steve sig

Steve Christ, Investment Director

The Wealth Advisory

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