Monthly Market Muhsings - August 2020

Markus Muhs - Sep 02, 2020
Why "the Dow" is not a relevant measure of stock market performance
Some recent changes in the composition of the Dow Jones Industrial Average have me once again thinking about the Dow and how completely… [be nice, Markus]... extraneous (thanks thesaurus!) it is as a measure of the stock markets as a whole. Okay, I’ll admit it: I’m an anti-Dow snob.
 
Every night I see “the Dow” reported in the nightly news. Why the Dow? In Canada we usually get reports of what the TSX Composite did today (a cap-weighted* index made up of around 250 of the largest out of 1500 or so companies listed on the TSX), along with the Nasdaq Composite (a cap-weighted index of almost all the 3300 companies listed on the Nasdaq), and “the Dow” (a weirdly calculated average of the prices of 30 arbitrarily chosen large companies that make up less than 1% of all stock listings the U.S.).
 
Despite my personal snobbishness, I don’t blame clients if they are more in tune with movements on “the Dow” than they are the S&P 500 (a cap-weighted index of the 500 largest U.S. companies, calculated exactly the same way as the TSX Composite and all other mainstream indices) because the news always likes to refer to "the Dow". On days when the markets crash, the noisemedia can make a lot more hay out of scary headlines of 4-digit Dow “losses” than 3-digit S&P 500 points (of course, they’ll never talk in terms of percentages). Works the other way too, when the current President of the U.S. proclaims his success with the economy by measure of thousands of Dow points gained (and then gained again). 
 
 
Back in university, in an introductory course to the financial markets, I recall a professor being very clear: “The S&P 500 is an index, the Dow Jones is not an index, it’s an average…” At that time I already knew more or less how indices are calculated (see asterisk at bottom) but when I learned how the DJIA was calculated it blew my mind. 
 
Why the DJIA is such a weird quirky average, instead of a proper index, probably can be explained simply by the fact that they didn’t have a lot of calculating power back in 1885, when it was founded, beyond calculating a simple arithmetic average of stock prices on paper. In short, the DJIA is literally calculated by averaging stock prices (not the actual values of companies), with some quirks to account for stock splits over time. 
 
Again, only 30 companies factor into the average—and not necessarily the 30 largest companies—but 30 arbitrarily chosen companies. My Dow-snobbishness comes to the forefront after they recently deleted Exxon Mobil, Raytheon and Pfizer from the average, while adding Salesforce, Honeywell, and Amgen. Why those particular companies? 
 
Further, if they keep deleting companies after they slide out of favor (XOM was once the largest stock in the world) and adding them after their rise (the DJIA only participated in AAPL’s rise from 2015 onward, after it replaced AT&T), how does this thing even remotely approximate the true growth in the markets? Perhaps it’s for that reason that the average, once worth almost exactly 10 S&P500s, is now worth only 8. In other words, it trailed the S&P 500’s performance fairly noticeably over the last decade.  
 
The second largest stock in the world, Amazon, is not even part of the DJIA, nor are the fourth (Alphabet) and fifth (Facebook) largest. Amazon (around $3400) and Alphabet (around $1600) with their 4-digit prices might actually mess with the average too much anyway. Strangely also, in the latest weightings of the average, there are 4 companies outranking $1.6 trillion Microsoft, including newly-added Salesforce and Amgen, purely because their stock prices are higher (their companies combined are worth less than MSFT). Are Salesforce or Amgen really more relevant to the U.S. stock markets as a whole than Microsoft or Apple?
 
In terms of Apple, now by a fair margin the largest publicly traded company in the world with a market cap of $2.2 trillion at the time that I write this, this is where the ridiculousness of the Dow really comes front and center. Prior to their recent 4 to 1 stock split, AAPL was the largest component of the DJIA, at over 11%. That in itself was ridiculous, that one company (representing a bit under 6% of the total market) made up more than a tenth of the DJIA. But now, after the split, because its price is lower (not that it’s a smaller company!) it ranks 18th among DJIA constituents, and constitutes less than 3% of the average.
 
 
So, anyway, if anyone wonders why the DJIA doesn't find a place on my monthly market tables, above, now you know. I only deal with real market indices, and with so many of us indexing by way of funds linked to either the S&P 500 or the total U.S. market we shouldn't care about "the Dow" anyway.
 
For that matter, I might have to get a bit snobbish around the S&P 500 too, which doesn't include Tesla, now the 8th largest stock in U.S. total market ETF holdings. I think it might be a bit too pretentious of me to track the Wilshire 5000 index in place of the S&P 500 above.
 

Markus Muhs / CFP, CIM

Investment Advisor & Portfolio Manager


*Capitalization-weighted, as opposed to equal-weighted or any other type of weighting, means that companies are weighted in the index calculation by their actual size. The largest company has the largest weight and so on. Effectively, the S&P 500 sums up the market capitalizations of all companies (ie: 2.2 trillion for Apple, 1.6 trillion for Amazon, 1.6 trillion for Microsoft, etc) and divides that massive number of nearly $30 trillion by some kind of divisor to get a 4 digit number, like 3500, that fits a little better onto a table.
 

Subscribe to our newsletter