Why the Dow is a pretty stupid indicator
Created by Charles Dow in 1896, the Dow Jones Industrial Average is perhaps the most well known and widely followed indicator of the U.S. stock market.
But I think the Dow is pretty stupid, and not really worth following at all. Why? Because the Dow Jones is a “price weighted index.”
This means a Dow stock with a price of $200 is weighted 10x as heavily in the Dow as a stock with a price of $20. As we all know, price per share, without any consideration to the # of shares outstanding, tells us nothing about the relative size of the stock. Conversely, the S&P 500 is a market cap weighted index, not a price weighted index, which makes it a way better indicator of the market as a whole, in my opinion.
For example, just 8 of the Dow’s 30 companies account for 48.1% of the index.
IBM 11% of Dow, PE=13.3
CVX 6.39%, PE 9.4
MMM 5.57%, PE 15.9
CAT 5.45%, PE 11.6
MCD 5.36%, PE 17.8
XOM 4.94%, PE 9.5
UTX 4.92%, PE 15.5
TRV 4.38%, PE 12.6
Total % of Dow = 48.16%, Avg PE = 13.2 (The S&P’s average PE is 15, making these 8 Dow components about 12% cheaper that the S&P on a strictly P/E basis)
Therefore, these 8 companies will have a disproportionate impact on the Dow going forward. As you can see, they seem fairly cheap as a group. It’s plausible that the Dow could rocket 15k or 17k, if these 8 companies to well over the next couple of months/years, while at the same time, the S&P/overall market could be stagnant or even decrease during the same timeframe.
The rest of the Dow Jones components and respective weightings can be seen here: http://www.indexarb.com/indexComponentWtsDJ.html
Now, let’s look at a few absurd examples of the Dow in action:
Example 1 - IBM has a 231Billion mkt cap and accounts for 11.25% of the Dow’s weight. GE has a very similar 234B mkt cap, but only accts for only 1.24% of the Dow’s weight. So IBM and GE are nearly the same size, in terms of market caps, but IBM is weighed about 9x as heavily in the Dow, just because IBM is priced around $200, and GE is about $22.
Example 2 - CAT only has a mkt cap of about 64B, yet represents 5.45% of the Dow. So CAT pulls almost 4.5x the weight that GE does in the Dow, yet GE is about 3.6x larger that CAT.
In conclusion, due to the fact that the Dow Jones is weighted based on an essentially meaningless metric, I see no reason to pay any attention to it. Just stick with the S&P 500, which makes alot more sense, in my humble opinion.
But maybe you see the Dow differently?
I'd love to hear your thoughts on this index, or this post.