Why The Dow Is An Imprecise Measure Of The Market

| About: SPDR Dow (DIA)

While I'm not a believer in most conspiracies, the recent change in the components of the Dow Jones Industrial Average (NYSEARCA:DIA), or DJIA, better known as the Dow, arouses some suspicions on the part of some members of Wall Street.

Wall Street clearly wants us to believe that the stock market is the absolutely best place to invest our money. Its livelihood depends on it. Every year, Wall Street extracts about 2% of our entire stock market portfolio value in mutual fund management fees and transfer fees (more than 2% if we make changes in our holdings, like shifting from one mutual fund or stock to another).

In one important sense, Wall Street doesn't really care if the market goes up or down - it collects its fees regardless of how well its recommendations perform. But Wall Street very much wants us to believe that the market is destined to move higher over time, substantially higher. That way we will hang around and let the managers extract those sweet fees every year, in good years and bad.

Wall Street has been extremely successful in promoting its message. If you ask the average guy on the street how much the stock market goes up every year, he is likely to say 9% or 10%. No matter that Warren Buffett has calculated that the average gain over the last century has been only 5.3%. A strong case could be made that the next 100 years might very well result in absolutely no growth, but that is a subject beyond the purview of this article.

A huge percentage of Americans look to the Dow as their gauge for the market. After all, it has been the longest-running index around, over 100 years in business. Lots of excitement is generated every time the Dow hits another 1,000-point milestone. "Wow, the market is soaring - the Dow is flirting with 15,000," is a familiar line.

When the 6 o'clock news reports that the market had a triple-digit gain, it is referring to the Dow. Popular opinion equates market performance with the Dow, and Wall Street loves that, because it can easily tweak how the Dow performs.

The Dow is made up of only 30 companies, but they are an ever-changing mix of characters. In the beginning (1896), they were all industrial companies, as the name suggests. Things are dramatically different now. For example, one of the newest additions to the Dow, Goldman Sachs (NYSE:GS), influences the Dow by more than four industrial companies combined - Pfizer (NYSE:PFE), Cisco Systems (NASDAQ:CSCO), General Electric (NYSE:GE) and Intel (NASDAQ:INTC). Goldman doesn't really make anything, not even loans. One might wonder why they still call it the Industrial Average.

This week Wall Street gave us a vivid example of how the Dow is managed to make it look better than it is. What did it do? On the surface, it looked innocuous enough. It removed three companies from the index - Bank of America (NYSE:BAC), Alcoa (AA) and Hewlett-Packard (NYSE:HPQ), and replaced them with three others - Nike (NYSE:NKE), Visa (V) and Goldman Sachs. If you wondered why these changes were made, the Dow Jones index committee cited the low stock prices of the three companies being removed as well as a "desire to diversify the sector and industry group representation of the index."

Let's look at the implications of these changes. It is important to understand that the index counts the absolute size of the stock price rather than the size of the company's market cap as the critical number. This creates some bizarre results. For example, Goldman Sachs will have about five times the weight of Microsoft (NASDAQ:MSFT), which has triple Goldman's market value.

The three stocks removed from the Dow had an average price of about $15 while the average price of the three added to the index was $135. Since the absolute change of the stock price is what is counted in the daily calculations of the Dow's value, no matter what percent the stocks go up, the Dow will now go up by about nine times as much with the three new companies as it would have gone up with the three companies which were removed. It's that simple, a blatant manipulation of the numbers.

As the old saying goes, statistics don't lie, but liars use statistics. This is exactly what is happening here. It is so obvious that the perpetrators should be embarrassed. But it is business as usual, this time carried out by an anonymous committee.

And it gets worse. The typical methodology is to remove companies that are doing the most poorly and replace them with ones that are doing much better. This time around they removed Alcoa which had tumbled about 12% in the last year and replaced it with Nike which had gained 30%. It's like creating an all-star team of the very best-performing companies and broadcasting to the world that this is the average of all companies in the market.

And it gets ever worse. When any new company is added to the Dow, there are a large number of mutual funds whose charter requires them to mirror all or part of their portfolio with the Dow components. This results in billions of dollars flowing into the Dow additions for no reason other than they are now Dow components. All this new money will push up the stock of those companies and the Dow will artificially be propelled higher.

Of the original Dow companies (there were only 12 at the beginning), only GE remains. It might be interesting to calculate what the Dow would look like today if only GE were used instead of the new components which have changed 53 times over those 117 years. Comparing the chart of GE vs. the Dow over the past five years is revealing in itself:

Over this period, GE has fallen about 20% while the Dow has increased almost 35%. What does this say about how the true market has performed? Has it gained 35% or lost 20%? There is quite a difference between those two numbers.

Bottom line, the Dow should be considered as an all-star collection of the 30 best companies the selection committee can find rather than an indicator of how well the stock market (on average) is doing. The average market really isn't doing that well. However, Wall Street can be counted on to continue promoting the myth that the Dow Jones Industrial Average is the venerable old index that truly measures how well the stock market performs over time.

The Standard & Poor's 500 (NYSEARCA:SPY) is far and away a better measure of "the" market compared to the Dow, although even this larger index is guilty of periodically (often several times a year) substituting stronger companies for declining ones. This results in an artificial upward bias to SPY as well. Unfortunately, both the Dow and SPY overstate how well the market as a whole has performed, although the Dow Jones Industrial Average is by far the more inaccurate index. In reality, we should remove both the words "Industrial" and "Average" from its title.

Hopefully, this article will help those of us whose own portfolios haven't measured up to the Dow's performance feel a little better about not doing so well in comparison.

Disclosure: I am long NKE, SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.