It's Time We Ditch the Dow
The "Industrial" AverageWhile the word "industrial" is still in the index's title, it's important to recognize not every company in this index is an industrial one. Companies like Goldman Sachs(GS), JP Morgan Chase(JPM), and Microsoft(MSFT), aren't exactly what I would consider "industrial companies", yet they all have claimed a spot in this price-weighted average. I understand the historical importance of the name, but that just bothers me. If the index wants to include companies that aren't by definition "industrial", it should at least include some of the largest U.S. companies that are not already on the list. Companies like Alphabet(GOOGL), Amazon(AMZN), Facebook(FB), and Berkshire Hathaway should be included, with a combined market capitalization of just under 3 trillion USD. All of those companies listed have a higher market share than all but two DJIA companies.
CalculationThe price-weighted nature of the Dow is easily the worst part about it. We live in the age of information and we should stop looking at a poorly calculated index as a measure of well-being for American equities. The formula for the DJIA is below.
It's a fairly simple formula, where P is the prices of the 30 stocks that comprise the index, and D is the Dow Divisor. The Dow Divisor value is currently 0.14523396877348, so that means for every $1 change in a price of any particular stock which is included in the index would equate to a 6.885441528900792 point movement in the index. For example, if Exxon Mobil which is currently priced at $75.63 was to increase $5 to $80.63, assuming all other stocks in the index remain constant, the index would increase by 34.427 points all thanks to Exonn Mobil. Likewise, if the price of Exxon Mobil were to collapse amid a scandal thus halving its price in one day(unlikely, but possible) then that would result in a 260.373 point drop all as a result of one stock price. The divisor will be changed accordingly if any of the stocks within the index were to undergo a split.
Benching the BenchmarkThe Dow Jones is not considered very relevant on Wall Street. If you were to ask most any Wall Streeter whether they valued level of the S&P 500 or the DJIA more, you would overwhelmingly get the S&P 500 as a response. The S&P 500 consists of 505 American common stocks as opposed to the 30 found inside the Dow. The Dow in recent days has been showing some intense volatility as new economic data has struck fear into some investors who decided it was time to take profits from the prolonged bull market we've been in.
With a quick glance at a chart like that it would be natural to be frightful after seeing a dip in what seemed to be an invincible market which continued to climb higher each day. The strange thing to me is that it seems people are much more interested in the decline of the Dow than the increase. The fear factor of Dow's recent decline can be portrayed below in the Google Trends graph which shows the number of searches for a certain topic. Searches for the Dow Jones Industrial Average are in blue and searches for the S&P 500 are in red.
From the chart, it is clear the public is much more interested in the state of the Dow than the S&P 500, which is a far more telling of the overall health of equities in the United States. Also, I find it personally interesting that people are far more interested in the declines of the index rather than the rise of it.
The chart above pictured search trends in the last five years which correlates with the DJIA above it. Below I have done a more precise trend search to better depict how much we truly over hype the DJIA volatility relative to the overall market. This chart depicts worldwide search trends within the last 30 days which Google considered to be business news related to the two topics. Still with the same color coordination as the previous with the DJIA in blue and the S&P 500 in red.
Business news outlets spew fear left and right at the first signs of markets beginning to appear troublesome. We live in a click based era where you're far more likely to be drawn to an article about negative news rather than one of positive news. Which of these two headlines would grab more attention: 1. DOW FINISHES DOWN 350 POINTS FRIDAY FOR WORST WEEK IN 9 YEARS, or 2. In spite of volatility, DJIA still up 33% in the last 3 years. Obviously the first will attract more attention of course. I'm not saying we should completely ignore fearful cries about market woes, but we should take those fears into account and frame them into the big picture to give investors a better perspective. The United States economy is doing just fine. GDP is slowly increasing, unemployment is continuing to grind lower, inflation is coming close to the 2% target set by the Fed, and it looks like we will see several interest rate rises this year. The small correction in the markets is something people have been saying is coming since Trump was elected as the speculation of tax reform was almost immediately priced in. Markets continued to rise after that, but not for any particular reason. I think a slight dip is needed for markets to come down to a more natural level that is in line with the state of the economy.
Overall I think the DJIA has a rich history, but we should stop paying so much attention to it as an overall health gauge for the stock market. No mathematical model is perfect, but price weighting over a divisor that is prepicked for an index that contains only 30 stocks seems foolish. The media needs to understand how much fear they are striking into people's hearts when they throw around headlines and stories about the Dow crumbling. People who lived through the 2008 crash to see a significant chunk of their wealth wiped away shouldn't have to deal with artificial fear. Instead, business news outlets and media companies, in general, should have the best interest of their readers in mind by giving them the whole story instead of just a small slither so they can get their clicks and views.