DJIA: The Most Useless, Overused Tool on the Planet

Phil Davis submits: I finally found something I've been meaning to look up for some time: The current weighting of the DJIA! This became imperative today when I was shocked that the press blamed $18B General Motors Corp. (GM) for hurting the $3T index with its 6% drop.

Well, I checked it out and I am now more convinced than ever that the Dow is the most useless, overused tool on the planet!

Aside from the fact that it contains just 30 out of 8,500 stocks traded on the major exchanges, and aside from the fact that it contains some of the world's dullest companies, I now see that there is absolutely no logic to the weighting!!!

The Dow is "price weighted," meaning that weightings are determined based on the selling price of each stock, not the value of the company. This leads to some totally ridiculous outcomes:

General Motors Corp. (GM), which makes up .6% of the Dow's market cap, has a 2.1% weighting. That means that GM disproportionately affects the Dow by a factor of 350%.

General Electric Co. (GE), my favorite market indicator, with a $373B market cap, makes up just 2.4% of the Dow's daily move.

ExxonMobil Corp. (XOM) ($400B) at 4.5% could lose $12B in value (-$2) and that loss would not be reflected if General Motors Corp. (GM) gains just $2 (+$1B). How does this accurately reflect the economy? I've said on numerous occasions that GE should be replaced by Toyota Motor Corp. (TM), but this whole weighting system is insane!

Pfizer Inc. (PFE) ($203B) counts for just 1.9% of the index, while Boeing Co. (BA) ($66B) counts for 5.6%.

Wal-Mart Stores Inc. (WMT) ($201B), who sells $360B worth of stuff annually, is given a 3.2% spot, not even double Alcoa Inc.'s (AA) ($24B) 1.9%, who might hit $28B in sales if things go well.

Sharing top weighting with BA is another blast from the past -- International Business Machines Corp. (IBM) ($126B), with a 5.6% spot. I love IBM, and I think they're a great value, but they were at $83 in January and $90 in Jan '05 and $90 in Jan '04 and $80 in Jan '03... what exactly are we trying to measure here?

Number three in the weightings is 3M Company (MMM) ($57B), with 5.1%, 150% more than AT&T Inc. (T) ($123B) at just 2.1%. AT&T made $1.8B last quarter, more then 3M made in its best 2 years...

Another insult to the tech sector is Intel Corp.'s (INTC) ($118B) 1.4% weighting, as well as the unbelievable 1.8% (less than GM) given to Microsoft Corp. (MSFT) ($277B). Microsoft would have to add $22B, more than GM's entire market cap, to make up for GM's 6% loss today.

In addition to all this misleading data, you can't even trust the number you see in the morning!

According to Wikipedia:

"Another issue with the Dow is that not all 30 components open at the same time in the morning. Only a few components open at the start, and the posted opening price of the Dow is determined by the price of those few components that open first and the previous day's closing price of the remaining components that haven't opened yet; therefore, the posted opening price on the Dow will always be close to the previous day's closing price (which can be observed by looking at Dow price history), and will never accurately reflect the true opening prices of all its components."

So stop watching the Dow!!! I know, it's impossible because the press treats it like it's the entire market, but it is a flawed and nearly meaningless indicator of what is really going on in our economy.

Read all of Phil Davis's articles on Seeking Alpha.

Comments

[MarineCorpsVet:]

Alright, you've told us what not to use. In your opinion, what should we use?

2006 Oct 08 11:56 AM

[David Neubert:]

The weightings are insane you are right. And the index does respresent some pretty dull companies. The weighting system is an accident of a pre-computer age it had to be calculated by hand in the beginning.

I used to complain about the DJIA all the time until someone showed me the daily correlation between the DJIA, the S&P500 and the OEX; oddly enough, they were super correlated on daily moves. (long term though - totall sillyness - but that explains why very little real money is indexed to the Dow)

2006 Oct 09 12:11 AM

[Ricardo Arroja:]

Thanks Phil for detailing the Dow. I agree - the Dow is useless. David Neubert argues that the correlation between the Dow, the S&P and the OEX is high. However, the Dow is trading at all time highs while the S&P and the OEX are still way below their previous highs. So, basically, they change in the same direction but the Dow either falls less or rises more than the others. I think Phil's post highlights why: the Dow's nature, a price weighted index (not a market cap weighted index), allows rising stocks to exponentially impact the index. Whereas, in a market cap index, rising stocks will impact the index in a linear manner. Last week, there was also a great article in TradingMarkets.com regarding the price mechanism within the Dow - apparently, only four stocks (Caterpillar, Exxon, Philip Morris and one other) among the Dow are trading higher than in 2000. I haven't confirmed that info but the source is credible. So, a handful of such companies are contributing more to the Dow as they rise in price. On the other hand, the "dogs" are contributing less as they decrease in price. The index is skewed and biased. Not to mention the "survivorship bias" - eventually, the dogs are eliminated from the index and a potential star is put in place instead.

The true market benchmark is the US is the S&P500. Or, any other meaningful market cap weighted index. Price weighted indexes are simply flawed.

2006 Oct 09 05:30 AM

[David Neubert:]

Don't get me wrong the Dow is a stupid long term benchmark for the market. However every index has it's flaws: For example: The S&P500 is not market cap weighted but market float weighted to make it more tradeable and easier to use for index funds.

Market Cap Weighted indices have problems because they represent the market of a country not the economy. Large Profit producers can have small weightings during a bubble in one sector. Float weighted indices penalize companies with small floats but large market caps like Berkshire Hathaway, Equal weighted indicies over represent small companies, The NDX is cap weighted with a limit placed to reduce MSFT because it would be too big, the most widely used Brazilian Index, the Bovespa uses a trading volume weighting, The Wisdom Tree Funds use Dividend weightings, MSCI uses economic participation for sector and country weightings but float for individual shares.*

*Tthese facts are from memory have have not been checked yet)

2006 Oct 09 11:35 AM

[Philip Davis:]

Nice summary David! I agree with Ricardo though, you have to trust the S&P and I find the NYSE usable but the important thing is for people to know that it's flawed as it is the focus on this very misleading number that is doing the real damage.

2006 Oct 09 08:09 PM