Has the Dow Really Escaped the Bear?

The past year has been extremely unkind to the equity markets. As of March 23, 2001, the NASDAQ Composite had retreated 62 percent from its closing high in 2000 while the Standard and Poor’s 500 had given back 25 percent. Both of these benchmarks are in “bear market” territory, which occurs when an index falls by more than 20 percent from its closing high. The Dow Jones Industrial Average (DJIA) had been a relatively safe haven as it had only given back a more modest 19 percent since its all-time closing high of 11,723 on January 14, 2000. Thus the Dow Jones Industrial Average had seemingly escaped bear market territory. Or had it?

History of the Dow Jones Industrial Average

Charles H. Dow first introduced the industrial stock average on May 26, 1896. It consisted of 12 industrial companies. He calculated the average by adding the prices of the 12 stocks and dividing by 12. On October 7, 1896, The Wall Street Journal began including the index in its daily publication. Charles Dow later expanded the number of companies to 30 in 1928. During the same year, The Wall Street Journal editors began calculating the average with a special divisor instead of the number of stocks. This divisor was adjusted for stock splits and for company substitutions. Originally 30, the divisor currently stands at .15369402. The calculation process remains the same however: simply add the 30 stock prices and divide by .15369402.

Price-weighted versus Value-weighted Indices

The DJIA is a price-weighted index and is calculated differently from the NASDAQ Composite and the Standard and Poor’s 500 (S&P 500), which are value-weighted indices. Value-weighted indices are calculated from market capitalization (shares outstanding x stock price) weights, or simply the market value of a company’s stock outstanding. If you had owned all of the shares of the 30 DJIA stocks, the value of your portfolio as of March 23, 2001, would have been $3.208 trillion. To measure your wealth changes going forward, you would have simply compared the market value of your portfolio to the value on some arbitrarily chosen benchmark date. Price-weighted indices, on the other hand, are weighted by share prices, which are seldom proportionate to market value weights. To create a price index for your portfolio, you would simply take one share of each company, add these, and divide by your divisor, which would be 30 in the absence of splits or substitutions.

Problems with the DJIA as a Market Indicator

Companies with higher share prices are given more weight in the DJIA calculation. Alternatively, companies with lower share prices are given less weight. These weights are often poor proxies of market capitalization weights. For example, as of March 23, 2001, AT&T only carried a DJIA weight of 1.46 percent but had a market capitalization of $80.2 billion. Minnesota Mining and Manufacturing (3M), on the other hand, had a DJIA weight of 6.96 percent but only boasted a market capitalization of $40.4 billion. The problem is that AT&T’s market capitalization was double 3M’s, but AT&T carried a DJIA weight that was approximately one-fourth the weight of 3M. The reason this occurred is due to the difference in share prices. AT&T had a price of $21.32 and 3M had a share price of $101.75.

Just how top heavy is the weighting system? Just four (3M, IBM, Exxon Mobil, and Johnson and Johnson) of the 30 industrial companies account for approximately 25 percent of the Dow Jones index value. The surprise is that neither General Electric nor Microsoft, which are the highest market capitalization companies in the index, is among the top four. Since 3M and other companies similar to it have held up fairly well over the past year, and carry relatively large weights, it is not surprising that the DJIA, with a price-weighted calculation, was able to boast its relative immunity to the bear market.

Another problem with a price-weighted index is that each dollar change of a DJIA component affects the average by the same amount, which is approximately 6.50 points ($1/.15369402). Let’s now consider the impact of price changes of the highest and lowest priced stocks on the DJIA. If 3M, the most expensive stock, increased by 10 percent one day, and the dollar gains/losses of all the other 29 companies cancelled each other out, the DJIA would increase by 66.2 points (101.75 x .10 / .15369402). If AT&T, the lowest priced stock, increased by 10 percent, holding all other stocks constant, the DJIA would increase by a scant 13.87 points (21.32 x .10 / .15369402). This hardly seems representative of market conditions when you consider the true creation of wealth for each of these companies. If AT&T increases by 10 percent, they would have added $8 billion dollars ($80.02 billion x .10) to market capitalization. 3M, on the other hand, if it increased by 10 percent, would add $4 billion dollars to market capitalization. Nonetheless, 3M currently accounts for 6.96 percent of the DJIA index value while AT&T accounts for 1.46 percent. As illustrated, the DJIA is subject to index swings that don’t necessarily result from proportionate wealth changes in the economy.

One may wonder how the DJIA performs over the longer term. Perhaps the biases of price weightings cancel each other out over time. The following table examines this issue by exploring the differences, if any, that may exist from using a price -weighted versus a market-value weighted index calculation. This table provides a list of each of the current DJIA 30 industrial companies along with their relative weighting on the DJIA, which is a function of the recent share price on March 23. In addition, the market capitalizations of each company are supplied for two dates: January 14, 2000 when the DJIA was at its high; and March 23, 2001. The data, which were gathered from Yahoo! Finance, are used to calculate a value-weighted DJIA.

Price-Weighted Versus Value-Weighted DJIA Calculations

Is the DJIA Dancing With the Bear?

The data in the table above indicate that the DJIA price-weighted loss was 18.9 percent from its closing high on January 14, 2000. However, the value-weighted DJIA company index yields a 26.6 percent loss during the same period. This is an interesting result because the article “Late Surge Pulls Industrials Out of Bear’s Jaws” recently appeared in the March 23, 2001 Wall Street Journal. The truth is that the “Industrials” were being chewed by the bear at that very moment. It is the DJIA calculation method that had allowed the index to avoid the bear. The Standard and Poors 500, however, was known to be in bear territory. When we apply the same calculation method to both indices, both were in bear market territory! In fact, according to the value-weighted calculation method, the DJIA was deeper in bear territory than the S&P 500. Who would have thought?

The dollar magnitude of the calculation difference can be illustrated with the following example. Using the DJIA as a market indicator, from January 14, 2000 to March 23, 2001, it would appear that we lost 18.9 percent of our original $4.3715 trillion in market capitalization, which equals $826 billion. The problem is that $1.164 trillion of wealth was actually lost by these 30 “blue chip” companies. This means that the DJIA calculation underestimated this wealth loss by $338 billion! This “error” is incredibly large. In fact, $338 billion is greater than the combined market capitalizations of 11 of the DJIA companies: Alcoa, Boeing, Caterpillar, DuPont, Eastman-Kodak, General Motors, Honeywell, International Paper, McDonalds, 3M, and United Technologies as of March 23, 2001.

Too Much Reliance on the DJIA?

Approximately $338 billion of wealth loss is unaccounted for by the faulty DJIA price-weighted calculation from the period of January 14, 2000 to March 23, 2001. With such a crude proxy of the market we would hope that the DJIA is not employed in any critical financial decision-making processes. But it is.

It is a puzzle that we — investors as well as more casual observers — put so much reliance on the DJIA as a barometer of the economy! Perhaps the last institution you would expect to rely on the DJIA as a financial indicator would be the New York Stock Exchange (NYSE). However, in actuality, the NYSE relies heavily on the DJIA, not only to communicate market activity, but also for trigger points that control trading curbs and collars.

The DJIA serves as the benchmark by which trading collars and circuit breakers are activated. The NYSE Collar Rule (Rule 80A) sets a restriction on program trading and is triggered if the DJIA moves up or down by 210 points. The idea is that these curbs on trading, also known as collars, will limit the daily damage by restricting activities that might lead towards greater volatility and large price moves, and encouraging trading activities that tend to stabilize prices. If the DJIA retreats to 100 points or less, the collar is lifted. Program trading, by definition, occurs when a basket of 15 or more stocks from the S&P 500 index, valued at $1 million or more, is traded simultaneously. If this trigger occurs, program trading curbs are initialized, which means essentially that program trading must be done by hand, so to speak.

Another DJIA-reliant restriction is the NYSE circuit breaker. This restriction is also known as Rule 80B and was adopted in 1988. Rule 80B essentially halts trading for given periods of time depending on whether the DJIA falls by 10, 20, or 30 percent. For example, if the DJIA falls 1050 points (10 percent) before 2 p.m., trading will halt for one hour.

The Dow Can Misrepresent Changes of Wealth

This article illustrates the main flaw with the DJIA – It is a disproportionately weighted index that can misrepresent changes of wealth in the stock market. Although the Dow Jones Industrial Average showed an 18.9 percent decline thru March 23, 2001, the true loss of 26.6 percent was dampened by using a faulty, price-weighted, method. Once we apply the value-weighted calculation method to the DJIA components, the loss, which was substantially greater, qualified the DJIA for bear market territory. The surprising finding is that the DJIA components had actually lost a larger proportion of wealth than the S&P 500 companies.

It is important that investors realize that not all indices are calculated in the same manner. The S&P 500, which is a value-weighted index, is a broader and much more accurate indicator of the equity markets. Nonetheless, the DJIA is still the most widely used (and misused) financial barometer of the economy.

Please refer to these articles from previous issues of GBR . . .

SEC Requires Fair Disclosure

The Battle Over Merger Accounting

Managing Earnings . . . or Cooking the Books?