The case for ditching the Dow
The Dow Jones index is not broadly diversified nor representative of the US stock market as a whole. With such illogically chosen members, it should be consigned to history.
The Dow Jones Industrial Average has hit an all-time high, as anybody who has seen the headlines splashed across the front of this and many other newspapers will know. But should we care about this landmark?
No. The Dow’s methodological flaws are overwhelming and there is no reason for anyone to follow it. That it still generates so much attention is attributable to inertia and groupthink.
What is the problem with the Dow? As an index of only 30 stocks, the Dow is not broadly diversified and is not representative of the US stock market as a whole (the S&P 500, the world’s most widely followed index, is better for that purpose). Its stocks are not uniformly large enough to qualify as a "mega-cap” index, varying from Alcoa ($9 billion) to ExxonMobil ($399 billion). Try the Russell Top 50 instead. Neither, despite the name, is it a true industrial index (the S&P 500 industrials sub-index might work better for that).
Crucially, the Dow’s illogically chosen members are weighted by their share price, rather than their market valuation. This means companies that happen to have a high share price can outweigh larger companies with a smaller price per share.
This is ludicrous. For example. IBM now accounts for 11.1 per cent of the Dow and has a market value of $228.7 billion. ExxonMobil, back as the world’s largest company following the decline of Apple (never a Dow member), has a market cap of $398.5 billion, but a Dow weighting of only 4.8 per cent. Microsoft, a slightly larger company than IBM these days at $235.8 billion, accounts for only 1.5 per cent of the Dow. Meanwhile, Caterpillar outweighs both ExxonMobil and Microsoft, despite having a market value of only $58.8 billion.
Since the Dow hit bottom in March 2009, Caterpillar has accounted for 515 extra points on the Dow, while growing its market value by $44 billion. Meanwhile, Microsoft has grown by almost exactly $100 billion; and contributed 102 points to the Dow.
The Dow’s defenders point out that it correlates closely with the S&P 500, which is itself very close to an all-time high. But that merely cedes the point that it is the S&P that is worth watching.
They also point out that the Dow was the first attempt to create an index for the stock market, it has been continuously calculated for longer than any other and thus it still has historical interest. Long-run data are critical for establishing patterns in the stock market.
This argument was once valid, but in recent years the work of financial historians on both sides of the Atlantic has invalidated it. Economists such as Robert Shiller in the US, or Elroy Dimson, Paul Marsh and Mike Staunton in the UK, have built broader indices of the US stock market that go back into the 19th century. Technically, they are more robust than the Dow.
There is no reason for the Dow to exert such a thrall. Just look at the FTSE 30 index, devised by this paper as an index of UK stocks, launched in 1935 and for decades the most widely cited UK stock index. The FTSE 30 is still calculated, received a revamp in 2011 and is still published daily in the Financial Times.
But the FT Actuaries index, established in 1962, and then the FTSE 100, introduced in 1984, have long since superseded it. Milestones for the FTSE 30 now go unreported, even by the FT. No money is tied to it, as it is plainly a gauge of UK business and a historical vehicle, rather than an investment tool. This is for the good reason that an index of 30 large UK companies, given the scale of the London market, is an obvious anachronism.
As the FTSE 30 is currently down 42 per cent from a high set in the summer of 1999, it tells a radically different story from the FTSE 100, which is 4.1 per cent below a high set in 2007. But newspapers and stockbrokers alike have moved on to watch a benchmark that was more relevant instead.
For now, different media outlets feel compelled to treat the Dow as news because their competitors all do. But given only a little courage and dispassionate thinking, there is no reason why the Dow should not suffer the same fate as the FTSE 30.
There is a separate question, which is harder to answer. By robust measures such as the S&P, US equity markets are almost back to their highs of 2007, and could get there any day. This is a remarkably swift recovery from the 2007-09 implosion and a remarkable disconnect, both with the rest of the world and with most perceptions of the health of the US economy. How did this happen?
The Dow does not help answer this question. But as market perceptions can be self-fulfilling, attention to the Dow may have egged on the animal spirits that are pushing US stocks higher and fuelled that underlying disconnect. It really would be best if everyone could get used to ignoring the Dow.
Copyright The Financial Times 2013.