The new high of the Dow Jones Industrial Average (DJIA) has caused quite the commotion in the press lately. However, one could argue that the DJIA level may not be the best indicator of how the economy is really doing.
The DJIA, according to the S&P Dow Jones Company, was conceived by Charles Dow in 1896. He started with just 11 railroad stocks and price weighted them by a simple arithmetic average. In 1928, the index was increased to the current number of 30 stocks, all considered major factors in their industries. A "Dow Divisor" was also introduced. The divisor was used instead of a simple average in order to reduce distortion of the index for stock splits or when a company was added or removed.
Before we examine the nuts and bolts of the DJIA, let us review the new "high" the DJIA just hit. Using data from the St. Louis Fed, which takes into consideration inflation, you can see that the DJIA has not hit an all-time high yet in real terms. The DJIA still has a little more to go to beat the 2007 top, and even more to beat the 2000 top, which is even higher on an inflation-adjusted basis. So, in actuality, the DJIA did not yet reach record territory when considering inflation adjustments.
From the outside looking in, the DJIA seems like a good way to review the health of the market, and many people view it as that. However, looking at how the DJIA is constructed and how it is weighted can make the point clear as to why it is not really the best market barometer. First, the components of the DJIA represent about 27% of the float-adjusted market cap of the total stock market. Compare this to the S&P 500 Index, which captures 90% of the total market.
Another criticism of the DJIA's construction is how the component stocks are weighted. The 30 stocks chosen by S&P Dow Jones are price-weighted. Basically, this means that a stock's price, not the company's total value, determines how that company's stock adds to or subtracts from the index returns. To help understand this problem, let's use an example of a town that only eats pizza. These pizza-loving citizens have only two options, a large only pizza parlor and a small only pizza parlor. Accordingly, two small pizzas ($10 each) to every one large pizza ($20 each) are always sold. This means that the same total dollar value of pizzas is sold at each shop. Therefore, the total value of each pizza parlor is the same. Based on their total value, most indices would weight these parlors the same. However, the DJIA would weight the parlors by the price of one pizza. So, that would mean that since the small pizza is $10 a pizza, and the large pizza is $20 a pizza, the DJIA would weight the large pizza parlor at 67% and the small pizza parlor the remaining 33%, even though the pizza parlors have the same value. Many investors have asked why Apple's stock has not been made a component of the DJIA. Although there are probably many reasons, the pizza example sheds light on one big problem, the price of Apple's stock. If Apple were to be introduced into the average at its current price of approximately $450/share, it would dominate the performance of the index.
Today, the highest-weighted stock, IBM, makes up about 11.5%! IBM is probably not the first company that comes to mind when you think about a top market mover. What is more troubling is that IBM's influence is almost double the second highest-weighted stock in the DJIA, Chevron. This means that the performance of IBM can, and does, dominate this index. Should IBM have that much weight relative to others in the index? Microsoft has roughly the same market cap as IBM, but its weight is only around 1.5% of the DJIA. Exxon Mobile, the most valuable company (by market cap) currently, only makes up about 5% of the index; less than half that of IBM. And what about 3M? It has a market cap that is about 20% of Exxon, but has about the same weighting as Exxon in the index. All these inconsistencies arise because the DJIA is a price-weighted index.
The news media has become so excited about a new all-time high in the DJIA, however understanding what the DJIA represents and its makeup should help to remove most of the excitement. When trying to see how the overall economy and market are doing, look to indices that encompass more of the total market. For the U.S., the S&P 500 is a more appropriate, although not perfect, index. The S&P 500 is a market cap weighted index, meaning that higher valued companies are higher weighted in the index. This makes it easier to add or remove companies, and because there are 500 companies, not one company can completely dominate the entire index easily.