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JohnCLeven (82.79)

Why the Dow is a pretty stupid indicator

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February 04, 2013 – Comments (13) | RELATED TICKERS: IBM , GE , CAT

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.

Thanks,

-John

13 Comments – Post Your Own

#1) On February 04, 2013 at 6:51 PM, Option1307 (30.51) wrote:

Agreed, I never look at the DOW. Pretty much waste a of time!

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#2) On February 05, 2013 at 7:57 AM, lemoneater (87.47) wrote:

Shh! Don't give the secret away. Many of us see the Dow as a rabbit-chasing hound dog drawing the pack away from the fox who is the individual invester desperately trying to out run inflation.

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#3) On February 05, 2013 at 8:30 AM, catoismymotor (72.81) wrote:

The Dow is a sham. When you can add and take away companies at will to manipulate the *average* I consider that rigging the game.

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#4) On February 05, 2013 at 11:29 AM, miteycasey (91.01) wrote:

dead horse that's been beat to death.

The DOW is 'famous' for being 'famous'.

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#5) On February 05, 2013 at 1:19 PM, Schmacko (93.87) wrote:

While everything you say makes sense the two indexes bascially move up and down together in lockstep.  Both are up like 12-13% over the last five years.  Rise and fall at the same time with pretty much the same peaks and valleys.  You can use all the logic you want but if they travel roughly the same path and reach roughly the same destination does how the index is weighted really matter?

This is kinda of like coke vs pepsi to me.

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#6) On February 05, 2013 at 2:05 PM, JohnCLeven (82.79) wrote:

@Schmacko

Thanks for the reply!

At the time of this writing the Dow is up 8.84% over the past year and the S&P is up 12.41%, per google finance. (That's pretty significant)

However, you are correct, they do tend to move together over the longer term.

Frankly, I don't really understand why these two indexes follow each other so closely. With those 8 previously listed companies accounting for 48% of the index, it shouldn't logically match. It makes no sense to me.

I say we watch the two indexes over the next few years and see if a more significant divergence appears...i'm thinking we might.

Or maybe i'm a bozo, and missing something???

Cheers!

 

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#7) On February 05, 2013 at 2:18 PM, edwjm (99.85) wrote:

The index I prefer is the New York Composite.  It takes far more stocks into account then either the Dow-Jones Industrial or the S & P 500.

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#8) On February 06, 2013 at 6:26 PM, valuemoneygreen (80.89) wrote:

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.

So if the Dow was the one outperforming over longer periods of time 1975 1980 1985 1990 1995 2000 2005....look at the charts to see the results....which should be your benchmark? Tell me 5 reasons the Dow is a better benchmark and why. Just an exercise for you brain. Curious to see what you have to say.

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#9) On February 06, 2013 at 6:40 PM, valuemoneygreen (80.89) wrote:

I like numbers and common sense! :)

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#10) On February 06, 2013 at 7:32 PM, valuemoneygreen (80.89) wrote:

O and believe it or not..... an intelligent answer will make you much richer in the long run. So do a little research before you answer and put a little thought into it. People will give comments but not give information to help one make money. Part of your answer should be involved with your statement I restated in comment #8. You have part of the answer there. Look at a chart of the Dow index and S&P from 2000 till 2009. why such a big difference?....

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#11) On February 22, 2013 at 3:45 PM, JohnCLeven (82.79) wrote:

I apologize for making you wait 16 days, but I’ve been very busy and wanted to make sure I actually gave your questions some thought.

Question #1 - Name 5 reasons the Dow is a better benchmark than the S&P 500.

1.     The Dow is a better index because it contains a higher ratio of “market leaders.” The Dow is chuck full of companies that are pretty much undisputed leaders of their respective industries. (MCD, DIS, WMT, JNJ, IBM, INTC, and KO just to name a few) I’d say at least half of the Dow companies are “household names” that have built epic brands over many generations, and thus tend to wield some pretty significant pricing power, and scale advantages.

2.     The  Dow is a better index because it has a higher ROE than the S&P. After a bit of research, it looks like the S&P’s historical ROE is about 14%. However, it’s fairly cyclical with a range of about 9% to about 18%. Via a Finviz screen, it looks like the median ROE in the S&P is currently about 14.4%. The Dow however, with all its market leaders, currently has an average ROE of about 21%. (This was pieced together via a Finviz screen and then using Morningstar to fill in the blanks, as some data in the screen was simply absent.)

3.     The highly concentrated nature of the Dow (see quote in comment #8) makes the Dow a better benchmark. The more stocks in your portfolio, the greater the probability that you will have market-matching returns. Conversely, the more concentrated portfolio, the lmore likely that you will NOT match the market. The quality and price paid when constructing a concentrated portfolio will determine which way that volatility will take you, far above or below the overall market. If the concentrated portfolio is full of above average businesses, then the volatility is more likely to actually benefit you in the long run. 

4.     The lower turnover also makes the Dow better: Per Wikipedia, in the past 3 years, the S&P has had 43 component changes. 43/500 = 8.6% 3 yr turnover. Over that same timeframe the Dow has only made one component change. (UNH for KFT after spinoff) 1/30 = 3.3% 3 yr turnover. Common sense tells me that the less changes you make to an index, the more the index will actually reflect the success or failure of the businesses contained within it. As Graham famously said, “In the short term the market is voting machine, in the long term the market is a weighing machine.” 

5.     Outperformance makes the Dow better: Lastly, as you previously indicated, the Dow has historically outperformed the S&P 500. Perhaps, the greater proportion of market leaders, higher ROE, higher concentration, (of presumably above average companies) and lower turnover rate are probably why the Dow has outperformed the S&P? But point number #5 isn’t about WHY the Dow outperforms, just that the Dow DOES outperform. Growing up playing hockey, the kids that compared themselves to the average player (aka the S&P) didn’t improve as much as those who compared themselves to the best players in the league (the Dow). Psychologically, the higher you set your bar, the better you’ll probably do. The Dow has shown, historically, to be a higher bar than the S&P. That alone may make the Dow a “better” index for individual investors to follow.

Question #2. Which should be your benchmark?

In the end, I think it really depends what you’re looking for in a benchmark. If you’re looking for a diversified benchmark that encompasses about 75% of total market capitalization, will come closest to mirroring the overall market, and be as "average" as possible, the the S&P 500 is preferable to the Dow. But if you want a more concentrated, lower turnover benchmark, that generally outperforms the "average", the Dow is preferable to the S&P 500.

What do you think?

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#12) On February 23, 2013 at 11:19 PM, valuemoneygreen (80.89) wrote:

now pull up a chart of the Russell 2000 from 2/23/2009 till 2/23/2013. compare the results to S&P 500 and the Dow.....which index would you have wanted to be in? which the least? You made some very important points in your reasonings btw.....especially in #1!

Now I am going to say a bunch of stuff and it might seem all over the place a bit but I just like blurting out thoughts.

I told you to look at time frames I knew it looked like DOW outperforms over a longer period but really it doesn't. My reasoning behind telling you this was to realize when the market is going up the S&P will outperform and when the market goes down the DOW will usually outperform this shows more when you look at the Russell 2000. This is because small caps stocks take more of a roll in making up the average. What do you always look at 1st when buying a company? EARNINGS! Have you ever heard me preach about earnings and earnings consistancy in my pitchs or commments? :) earnings ALWAYS drive price or it should if you are buying the company outright. S&P average DOES do a better job of mirroring the overall market. It should be your benchmark. But it is more effected than the DOW's average because smaller cap equities tend to vary by a greater margin when the economy is picking up or slowing down. Why because of earnings. Think about your comment #1 and the companies you listed. Did JNJ's or KO's earnings tank in 2008 or 2009? Nope. Did they go down less than the market? Yup. Now think of some smaller cap companies. When their is a financial crisis or the economy is suffering who's earnings get effected the most. Thus their price gets affected more. These two indexs end up being about the same because the way they are constructed. The people and the way the DOW was constructed wasn't made up by dumbies...and I know you were not implying that but there are reasons why. It is pretty neat on how it works out. Dow is made up on companies that have fundimentals and or large in size in their field pull they are passive.

Now if the economy keeps going up or starts ripping for some reason for a long amount of time with no corrections the S&P will keep outperforming. But this doesn't happen. We have recessions or the market gets scared. The DOW will outperform because of your #1 and #2 comments. And what I am saying about market cap and how it make up the averages.

Now why the DOW is a pretty GOOD indicator!

1. The Dow is a better index because it contains a higher ratio of “market leaders.” The Dow is chuck full of companies that are pretty much undisputed leaders of their respective industries. (MCD, DIS, WMT, JNJ, IBM, INTC, and KO just to name a few) I’d say at least half of the Dow companies are “household names” that have built epic brands over many generations, and thus tend to wield some pretty significant pricing power, and scale advantages.....

I stole that from you...hehe

I will steal this from you too

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.

Now how to profit from it. I would say from what is stated above I think it is reasonable that the market is not overvalued at current levels. AS INDICATED BY THE DOW INDEX! BECAUSE IT IS A PRETTY GOOD INDICATOR. We are in the 5th year of a bull market. Bull markets tend to last on average 7 years. In the later stages of a bull market large and MEGA cap stocks usually outperform the market. In the 1st 3 or 4 years in a bull run you would be better off to just buy the RUSSELL 2000 or look for steals. The market is now getting more fairly valued as shown by the S&P index. If I had a index to pick right now I would go with the DOW to outperform until the next big pullback. Of course this isnt really what we do. we r just looking for companies with consistant earnings power that we think will be worth a lot more in the future. I just thought it would be good to show you how the markets work from my perspective. And how I look at the averages and what they mean and indicate to mean. 

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#13) On February 24, 2013 at 12:13 PM, JohnCLeven (82.79) wrote:

Thanks for the insight. You definitely raised some good points.

Perhaps YOU should do some more blogging...i'd love to hear what else you have to say.

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