How The Dow Overstates Actual Market Performance

by: Terry Allen

It is critical for Wall Street to convince the public that the stock market is the absolute best place to put your money. Its very life-blood depends on it. Wall Street collects billions of dollars in mutual fund fees regardless of whether the market goes up or down. Nice work if you can get it (and Wall Street does get it, and best of all, doesn't even have to tell investors that they are taking fees out of every mutual fund out there).

Of course, if the market does manage to go up, Wall Street collects even more in fees and commissions because existing balances become higher, and more money is shifted from alternative investments and directed to the stock market.

So Wall Street loves higher markets, but they are fundamentally more interested that the allusion of higher markets persists regardless of what the actual performance might be. Even if the market does not go up, the allusion that it rises by a healthy margin every year (at least over the long run) is critical to Wall Street being able to continue to keep its yachts afloat. The allusion is the key. It is far more important than reality, and Wall Street goes to an extreme extent to make everyone believe the market is a great deal better than it really is.

Wall Street is guilty of setting forth lies and then repeating them enough times and in enough different ways that they become part of everyone's belief system. They methodically fudge the numbers in a variety of ways to perpetuate the illusion, and then publicize the heck out of those fudged numbers.

If you ask the ordinary man in the street how much the market goes up each year over the long run, on average, the answer will probably range from 7 to 10 percent. Warren Buffett, on the other hand, in his 2008 letter to Berkshire Hathaway stockholders, reported that the average annual compounded gain for the past 100 years has been 5.3%.

Inflation has run about 2% or 3% a year over this time (although the official inflation rate is also fudged, this time by the government, but that is outside the purview of this article). That makes the real net gain about 3% a year. That is better than putting your money in a coffee can and burying it in the back yard, but it is nowhere near the numbers promulgated by Wall Street.

Note: Wall Street pundits argue that Buffett's number does not include dividends (which have averaged about 2% a year), but they ignore that about the same amount (or more) is extracted each year in mutual fund fees. Since the two omitted numbers are about the same, the 5.3% number seems to be the most accurate measure of what has really gone on. (Most informed people believe that the number in future years will be far less than the last 100 years.)

The primary tool in Wall Street's bag of tricks is the Dow Jones Industrial Average (the Dow). To most Americans, the Dow is "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 1000-point milestone. "Wow, the market is soaring - the Dow is flirting with 16,000," 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 (even if half its value is determined by a mere 9 companies), and Wall Streeters rejoice. The gullible public is swallowing their Cool-Aid.

The truth is that the Dow is an inaccurate measure of the market's performance, and it is blatantly manipulated on a regular basis to give the impression that the stock market is performing better than it is.

The Dow is made up of only 30 companies. In the beginning (1896), they were all industrial companies, as the name suggests. The actual Dow value is calculated by adding up the dollar value of each of the component companies and dividing by a single number called the divisor to adjust for previous changes in the composition of the companies. The present divisor works out for the Dow to go up by 6.42 for every dollar that one of the component companies goes up. This method of calculating an index was appropriate a hundred years ago before calculators were invented, but it is patently ridiculous today.

A better measure of impact of a company would be its market cap rather than its stock price, as the S&P 500 uses. Using absolute prices rather than market cap creates some bizarre results for the Dow. For example, Goldman Sachs (NYSE:GS) has about seven times the weight of Microsoft (NASDAQ:MSFT). If MSFT gains 5%, the Dow will pick up 12 points. If GS gains 5%, the Dow will soar 86 points even though MSFT has a market cap value which is three times greater than GS. This means that Goldman's effect on the Dow is 21 times greater than it should be based on company size. It just doesn't make mathematical or rational sense.

Wall Street manipulates the Dow number by weeding out companies that aren't doing well (or have failed) and replacing them with companies that are doing better. Of the original Dow companies (there were only 12 at the beginning), only GE (NYSE:GE) remains.

The major justification for the Dow's continued popularity in spite of its flaws is that it is the longest-standing measure of industrial performance. In reality, the only thing consistent about the Dow Jones Industrial Average has been its name. The actual components have changed 53 times over its 117-year history.

Every company except GE has either disappeared or was performing so poorly that it was replaced by faster-growing companies. This year, three companies were removed from the index - Bank of America (NYSE:BAC), Alcoa (AA) and Hewlett-Packard (NYSE:HPQ), and replaced them by three others - Nike (NYSE:NKE), Visa (V) and Goldman Sachs . Two companies that were eliminated actually manufactured something (AA and HPQ) but only one of the additions did.

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." Replacing one bank with another doesn't really seem to be diversifying very much, and nobody seems to have noticed that the primary reason a company has a low price is because it has not been performing as well as other companies. But from Wall Street's perspective, if your goal is to make the world believe that the stock market is moving inexorably higher, it is imperative to weed out the low-priced ones which coincidently are also the lowest performers and replace them with more promising alternatives.

The most interesting addition was Goldman. It doesn't actually make anything, not even loans. It earns its money by trading in Wall Street's casino. One might ask how it gets counted in an industrial average. (A personal injection here - I believe the addition of Goldman could eventually backfire on the Wall Street media machine. Trading profits are volatile - good one year and bad in others. What will happen to the Dow if Goldman makes some bad trading decisions, or implodes like Lehman did? It is a little scary to contemplate. You can bet that GS will get deleted from the Dow in a nanosecond.)

For an example of how Wall Street's redefining the Dow ends up with inaccurately bullish numbers, consider General Electric. This is a truly industrial company and is probably the most logical company to include in an industrial index. It is surely more representative of industrial activity than many of the other components (particularly the banks). GE is trading about $26 and the Dow is about 16,000. When the new century came upon us in 2000, GE opened at a split-adjusted $50 and the Dow opened at 11,500.

Thirteen years later, the Dow has gained 4500 points, or about 39%. That works out to an average of only 3% a year, a far cry from what Wall Street is proclaiming as the historical average (they prefer to choose other time periods, like 100 years, which would have given them more opportunity to manipulate the numbers). But 3% a year isn't bad. At least it might have kept up with inflation.

The astonishing fact here is that if GE were the only component of the Dow, and since it fell nearly 50% over those 13 years, the Dow would be trading about 6000 today rather than 16,000. A retiree who had a significant amount of his nest egg invested in GE (a likely possibility because the company has been one of the most popular and widely-held securities for many years) he might look at the Dow and assume that he was nearly 40% ahead of where he started at the turn of the century. But if he checked out his personal brokerage account he would see that it had lost half its value. Wall Street would rather have him celebrate the 16,000 number and ignore the reality of his account balance.

The bottom line here is that the Dow Jones Industrial Average is a fabricated number that has little relation to the actual average performance of the market as a whole. For sure, it is not industrial in nature, and by no means is it an average. 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 out there.

And it gets worse. Every time a new company is added to the Dow collection and another company removed, the Dow is guaranteed to move higher. There are a large number of mutual funds whose charter requires them to maintain a portfolio that mirrors all or part of the Dow. This results in billions of dollars flowing into the new Dow companies for no reason other than they are now Dow components. All this new money will push up the stock prices of those companies and the Dow will artificially be propelled higher.

Meanwhile, billions of dollars will flow out of the companies removed from the Dow, and their prices will fall. Wall Street could care less. Those companies are no longer included in the Dow. The Dow will have moved higher because of switching companies, even if the average price of the old and new companies has not changed a penny. Wall Street mumbo-jumbo snake oil is a key ingredient in its Cool-Aid recipe.

As the old saying goes, statistics don't lie, but liars use statistics. This is exactly what Wall Street is doing, and has been doing with the Dow throughout history. It is so obvious that the perpetrators should be embarrassed. But it is Wall Street business as usual, this time carried out by an anonymous committee at the Dow Jones company.

Many pundits agree that the Dow is an anachronistic measure that should have been replaced decades ago by something that is a true indicator of stock market averages. But they continue trumpeting it as "the market" because it has correlated quite highly with the more widely-based S&P 500 index. (By the way, the company which selects the components of the S&P 500 has a familiar ring to it - Dow Jones.)

The S&P 500 index is also manipulated regularly by adding the faster-growing companies and weeding out the decaying ones. For the past couple of years, an average of 17 companies a year have been added (and subtracted) to and from the index, each time edging the total index number higher because of the required mutual fund activity. The S&P 500, too, is an all-star team of the best companies in the universe rather than the average, and every change in its composition manages to edge it up a bit higher.

In conclusion, if your investment accounts seem to have lagged behind what conventional wisdom says the stock market has done, don't be discouraged. The market, at least as measured by Dow, is hardly a fair measure of what has really gone on in the real world.

A recent headline proclaimed "Dow hits new high for 55th time in 2013." Wow, that is really impressive. We all must be richer than ever. What the article neglected to say was that adjusted for inflation, the Dow was 12% lower than it had been 13 years earlier, in March 2000. Just another glass of Wall Street Cool-Aid.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.