Rogue Missives -- Thursday, March 20, 1997 -- How Now, Dow?, by Louis Corrigan (RgeSeymour)

Rogue Missives

ROGUE ARCHIVES

Thursday, March 20, 1997

How Now, Dow?
by Louis Corrigan (RgeSeymour)
"The franchise value on the Dow is just so extraordinary. When average investors talk about what the market is doing, they're talking about the Dow."
--Jim O'Shaughnessy, money manager & market historian

O'Shaughnessy is surely right. For most Americans, the Dow Jones Industrial Average (DJIA) of 30 blue chip stocks remains the leading barometer of "the stock market." Mutual funds indexed to the rival S&P 500 may be the most popular investment vehicle on the planet. But the folks stuffing their money into these funds could probably tell you that the Dow's been dancing around 7,000 lately even if they can't guess the S&P within a thousand points.
Yet last week, the editors at The Wall Street Journal continued a long-standing tradition of changing what counts as the stock market. To be precise, they announced that the DJIA would be making some trades, effective this past Monday, March 17th. TRAVELERS GROUP <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TRV)") else Response.Write("(NYSE: TRV)") end if %> would replace WESTINGHOUSE ELECTRIC <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WX)") else Response.Write("(NYSE: WX)") end if %>; HEWLETT- PACKARD <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HWP)") else Response.Write("(NYSE: HWP)") end if %> was in, TEXACO <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TX)") else Response.Write("(NYSE: TX)") end if %> out; JOHNSON & JOHNSON <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: JNJ)") else Response.Write("(NYSE: JNJ)") end if %> would succeed BETHLEHEM STEEL <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BS)") else Response.Write("(NYSE: BS)") end if %>; and WAL-MART <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WMT)") else Response.Write("(NYSE: WMT)") end if %> would move into the location vacated by WOOLWORTH <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: Z)") else Response.Write("(NYSE: Z)") end if %>.
The changes were designed to lend greater weight to technology, health care, and finance, three increasingly important sectors of the U.S. economy. The immediate impetus for the update effort was Westinghouse's decision to spin off its industrial operations and become a pure play broadcaster within the next few months. With ABC and NBC already part of the Dow by way of Disney and General Electric, respectively, a new Westinghouse centered around the CBS network was expendable. Once the Journal editors began looking to make one change, others came up.
"It is a process that we take very seriously," said Jim Hyatt, statistics editor at the Journal and one of the editors involved in the decision. "We don't do it very often because we think that maintaining continuity is one of the important attributes of the average. We spend a good deal of time looking at possible candidates and analyzing how a change would affect the makeup of the Dow in terms of properly representing major parts of US industry."
The planned Westinghouse spin-off "made it more necessary to look closer" at the Dow, Hyatt said. "Since you don't change very often, if you're going to change one, you certainly want to look at all of them."
Travelers Group, the financial services giant, is actually making a return to the Dow. The packaging manufacturer American Can Co. entered the index in 1916 and eventually evolved into Primerica, a brokerage and commercial lending institution. The company was part of the average until 1991, when it was ousted along with two other stocks in the last shakeup of the index. Primerica then bought Travelers Insurance and changed its name to Travelers Group.
With Exxon and Chevron already Dow components, Texaco was expendable, particularly since energy has become somewhat less important in an information economy run on computers. Hewlett-Packard nicely fits the tech niche both because it's got a diversified product line, and, perhaps more important, it's traded on the New York Stock Exchange (NYSE).
Indeed, many have wondered why high-tech bellwethers Intel and Microsoft haven't received a Dow invitation.
"I don't think we've discussed that in public," Hyatt said. "We've always preferred the NYSE closes. That's been our policy on the industrial average. Now it is true that we have a Nasdaq issue on the transportation [average], but that's partly lack of transportation issues on the NYSE. I don't think we can go into what we discussed that we haven't announced."
He did add, however, that the Journal editors felt Hewlett-Packard offered "a wide piece" of the computer-related economy. "After all, the kind of equipment they produce is computer-based and computer-oriented and in some ways cuts across a wide variety of that part of industry."
O'Shaughnessy, president of O'Shaughnessy Capital Management and author of the recent business bestseller What Works on Wall Street, said he thought the Journal's preference for NYSE issues is "just a tradition and a mindset, frankly. Dow Jones is the keeper of an over hundred year old index, and there's a lot of tradition in that. It's really remarkable how closely the Dow has paralleled the overall larger market, the S&P and the other indexes. So I think at Dow Jones they have that mindset: to be part of the bluest of blue chip indexes, you've got to be traded on the NYSE."
Still, he says, "I certainly think they should have been more willing to look at an Intel or a Microsoft. If you want a prediction: Microsoft or Intel moves to the Big Board, they'll be moved into the Dow 30 like that."
The two other changes were no-brainers. Both Bethlehem Steel and Woolworth have fallen on difficult times and even canceled their dividends, excluding them from the various Beating the Dow formulas popularized by money manager Michael O'Higgins and practiced by the likes of O'Shaughnessy and Fools everywhere. Wal-Mart has eaten every other retailer's lunch, so they might as well sit at the counter once occupied by Woolworth. And with health care accounting for about a seventh of the nation's economy, the addition of the pharmaceutical giant Johnson & Johnson updates the average for a new era.
On the other hand, the recent changes once again remind us of the arbitrary aspect of this index that investors typically take for granted. For one thing, any index can rocket forward if you're allowed to knock out the laggards. In other contexts, economists refer to this problem as a "survivor bias" that makes the overall results appear better than they should otherwise be.
Of course, the index would have perished long ago without such constant revisions. In 1884, Charles H. Dow came up with the first list of 11 actively traded stocks, including nine railroads, and published them in the Customer's Afternoon Letter, a forerunner to the Journal. Dow's list went through three more permutations until his fledgling Dow Jones & Company came out with the first real version of the industrial index in May of 1886, a twelve stock average that still consisted of 10 railroads. Over the next three months, the average promptly lost a quarter of its value, dipping to an all-time low of 28.48.
The DJIA continued to be updated on a frequent basis, both before and after the Journal expanded the average to 30 industrials in October of 1928, just a year before the great crash. The Dow's current roster of blue chips has been a long time under development. Eastman Kodak was added to the index in 1930, AT&T in 1939, International Paper in 1956, Merck in 1979, Philip Morris and McDonald's in 1985, Boeing not until 1987.
Coca-Cola made it into the DJIA in 1932, only to get the boot three years later. It then spent half a decade in the wilderness, so to speak, before rejoining the Dow in 1987. IBM joined the list in 1932, was traded for AT&T seven years later, then rejoined the team in 1979, when it was the market's bellwether stock. The 1991 changes saw Caterpillar, Walt Disney, and J.P. Morgan enter the average while the ill-fated Navistar and the restructured USX were ousted and Primerica given a vacation.
Such a history of change, though, leads one to ponder some provocative what-if scenarios. According to O'Shaughnessy, the DJIA would already have broken 8,000 if the four recent additions had joined the index in 1991. Yet Primerica is far from the only or most dramatic Dow stock to be ousted from the index only to return later.
"What's really fascinating to look at is the early '30s," O'Shaughnessy said. "In the early '30s, Coca-Cola and IBM were both in the Dow and were thrown out until, in IBM's case, 1979 and in Coca-Cola's case, the mid-'80s. Had those two stocks simply been retained in the Dow, the Dow would be at like 10,000 now."
To entertain such possibilities is to travel in the realm of an alternative universe. If the market looks toppy at 7,000, what if it were well over 10,000 instead? Would Greenspan need a new straightjacket? Or would we long-ago have suffered a wave of interest rate hikes that sent the economy into recession and kept the Dow from pushing much above 8,500?
Of course, at least in theory, the market capitalization of IBM, Coca-Cola, or the entire Dow 30 would be exactly the same as it is now. Nothing would be different except maybe our perception. But would we actually feel more irrationally exuberant if the index's numbers were that much bigger? Or even more scary, would those Eliot Wave theorists somehow then make sense? ("Look! We've just been using the wrong numbers.")
In addition to such historical conundrums, it's worth adding some numerical ones. Calculating the DJIA may seem like black magic, but there is a relatively simple formula. As a price-weighted average, the index could once have been calculated by adding up the total stock price of the Dow stocks and dividing by the number of stocks in the index. But due to splits, spin-offs, and the component changes, the divisor has itself undergone countless divisions.
Richard J. Stillman offers a useful explanation of the issue in his 1986 history of the Dow. Assume, for example, that the index consisted of merely three stocks trading at $180, $120, and $60 per share, respectively. One could easily add up the numbers ($360) and divide by three to get an average of $120. But if the $180 stock split 2-for-1, the total would add up to just $270 now ($90 + $120 + $60), even though the real value of the stocks remained exactly the same. To solve this dilemma, one must divide the total stock price of the Dow components by some number that will make the equation equal the index value before the split ($270 divided by X equals $120). In this case, the divisor would be 2.25.
It's easy to see that, over time, the divisor gets smaller and smaller. Since 1986, in fact, the divisor has actually been a multiplier. Prior to the recent component swaps, the divisor was 0.32481605, which meant that every one dollar change in a Dow component was worth a 3.0787 point change in the Dow. In other words, a $4 per share increase in IBM would have give a better than 12 point boost to the DJIA. Since the additions have higher prices, overall, than the stocks being replaced, the recent change actually raised the divisor to 0.33098002, slightly reducing the multiplier effect.
The S&P 500 index is weighted by market capitalization. That's why strong growth by the largest companies has an enormous impact on that index. If the top 50 or so companies in that index perform well, it's virtually guaranteed that the index will move higher regardless of how the others fare. It's for this reason that the S&P can offer a somewhat distorted view of the market's overall strength. On the other hand, gains in the S&P represent a proportionate increase in the value of corporate America's top companies.
There are several peculiarities to a price-weighted average like the Dow. For one thing, a 10% increase in a higher-priced stock will actually pump up the index more than a similar increase in a lower-priced stock. A 10% increase in AT&T, for example, would boost the average by just over 10 points (3.5 x the multiplier) whereas a 10% jump in IBM's stock would add more than 42 points to the index (14 x the multiplier). This becomes even more peculiar when you realize that were IBM to split 2-for-1 so that it traded around $70 a share, the identical 10% price appreciation would now be worth only about 21 points (7 x the multiplier) to the Dow.
Of course, the divisor would be changed by the IBM stock split, but that change wouldn't be enough to compensate for the specific alteration in the pricing of IBM. In theory, the whole process works itself out over time. Changes in higher-priced shares impact the index more, but lower priced shares tend to have greater percentage changes and to rise more quickly, all other things being equal.
Still, the index could theoretically jump 50% without the overall market capitalization increasing by even half that amount if splits didn't constantly cut down the impact of market highflyers. The Dow, for example, could leap from 7,000 to 10,500 if one issue soared by about 1137 points, based on the old multiplier. If IBM suddenly captured all of the world's computer market and the shares jumped from $143 to $1280, its market capitalization would go from around $73 billion to $657 billion. Even so, this $584 billion increase in IBM would amount to just a 40% boost in the DJIA's recent $1.456 trillion market cap.
Caterpillar provides an even more dramatic example since its market cap is currently only $15.5 billion. If the company's tractors suddenly took over the world and the stock soared from $81 to $1218, the DJIA would turn in a blistering 50% gain even though overall market cap for the Dow components would have risen merely 15%, as a 15-fold boost in Caterpillar shares would add only $217 billion to its market cap.
This is all mere esoterica, however. As nearly everyone agrees, the Dow has more than held its own as a leading index of American business. The more interesting question is how the recent substitutions are likely to effect the Dow and the investment strategies built up around the index. Will the addition of stronger companies make it easier for the Dow to crack 8,000? Do the Beating the Dow strategies hold up?
"I don't think it's going to matter at all," O'Shaughnessy said. "I studied the Dow back to 1928. Over those years, there were innumerable changes made to the 30 stocks that were in the Dow. The Dogs of the Dow strategy continued to work throughout that time period. Stocks came in and went out, and it doesn't too much matter."
He said the index has taken on more of a growth profile in recent years with the addition of Coca-Cola, Disney, and other companies that don't fall prey to the traditional business cycle. The new additions continue the move away from such industrial cyclical issues. But according to O'Shaughnessy, "I don't necessarily think that's a bad thing." He said the addition of such companies would "absolutely" strengthen the Dow's performance and "certainly could" improve the Dogs of the Dow strategy, the ten-stock version of Beating the Dow. "Every time a strong company gets put in the Dow, I think it's a good thing because ultimately, every company has its cycles."
The Fool's own Robert Sheard (MF Dowman), commenting in his column last week, agreed that the changes seem like good ones that will make the DJIA more accurately reflect America's changing economy. He also noted that the changes had little effect on the Dow investment approach. Texaco would now be replaced in the list of top-ten yielders by Dupont.
On the other hand, Michael O'Higgins, president of O'Higgins Asset Management and author of Beating the Dow, is less sanguine about the Dow approach and the overall market.
"I think [the changes] will make a great deal of difference because the components that are being replaced are generally of a more cyclical nature. And I think it will hurt the ability of this program to work because you're getting much more homogeneity in the Dow in terms of all kinds of well-capitalized, 'growthie' type companies and away from the historical, cyclical bent of the Dow, which has been diminishing in recent years. This is putting another major dent in the cyclicality of the Dow components."
As a result, he thinks the Dogs of the Dow strategy will be hurt. "The major ingredient in this approach is that you have companies that are very susceptible to the business cycle, kind of basic industrial companies. So these are the ones that tend to get in trouble in bad times. They also tend to be more leveraged. So they either do very well or very poorly. Their fortunes vary a great deal."
To the degree that the Dow moves away from its basic industry character, he said, "I think you'll have less divergence in the performance of individual Dow components. I think you'll get more homogeneity than you had in the past." And that will mean less opportunity for investors looking to buy blue chips on the cheap.
Rogue asked if O'Higgins had a new strategy to work around this problem. "At the moment? Yeah. I wouldn't own any stocks," he said. "To me, the bond market is much more attractive than the stock market."
Indeed, O'Higgins falls very much in the camp of Warren Buffett, who last weekend indicated in a letter to Berkshire Hathaway shareholders that investors were very likely overpaying for all stocks.
"Anybody who knows financial history has to be bearish," O'Higgins said. "Only those people, perhaps like yourself or the Gardner brothers, who haven't been around long enough to have been through some market cycles and haven't studied financial history, or honestly believe this malarkey that this is truly a new era" could be anything but bearish.
"If you've done your homework, you have to conclude that stocks are at the most overvalued level in history. I'm unfortunately among that group."
On the other hand, both Buffett and O'Higgins have been wrong in their predictions before. In fact, Buffett has even said that the best thing about stock prognosticators is that they make fortune-tellers look good. If it seems presumptuous to argue with such experts, it also seems a little preposterous to argue that *all* stocks are overvalued.
Indeed, part of the problem with both the DJIA and the S&P 500 is that they allow commentators to make sweeping assumptions about "the market" based on the performance of a relative handful of stocks.
Clearly, all investors should be interested in how these corporate giants are faring. The DJIA does allow us is a quick snapshot of the market's overall strength. And that snapshot can be as striking as a fashion spread, even if the models have changed innumerable times over the years. Still, the market is always and ever an amalgamation of the thousand of markets for individual issues. Whether the Dow or the S&P 500 can tell us much about those specific markets is an altogether different issue.

--Louis Corrigan (RgeSeymour)

(c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool.

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ROGUE ARCHIVES

Thursday, March 20, 1997
How Now, Dow? by Louis Corrigan (RgeSeymour) "The franchise value on the Dow is just so extraordinary. When average investors talk about what the market is doing, they're talking about the Dow." --Jim O'Shaughnessy, money manager & market historian O'Shaughnessy is surely right. For most Americans, the Dow Jones Industrial Average (DJIA) of 30 blue chip stocks remains the leading barometer of "the stock market." Mutual funds indexed to the rival S&P 500 may be the most popular investment vehicle on the planet. But the folks stuffing their money into these funds could probably tell you that the Dow's been dancing around 7,000 lately even if they can't guess the S&P within a thousand points. Yet last week, the editors at The Wall Street Journal continued a long-standing tradition of changing what counts as the stock market. To be precise, they announced that the DJIA would be making some trades, effective this past Monday, March 17th. TRAVELERS GROUP <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TRV)") else Response.Write("(NYSE: TRV)") end if %> would replace WESTINGHOUSE ELECTRIC <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WX)") else Response.Write("(NYSE: WX)") end if %>; HEWLETT- PACKARD <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HWP)") else Response.Write("(NYSE: HWP)") end if %> was in, TEXACO <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TX)") else Response.Write("(NYSE: TX)") end if %> out; JOHNSON & JOHNSON <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: JNJ)") else Response.Write("(NYSE: JNJ)") end if %> would succeed BETHLEHEM STEEL <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BS)") else Response.Write("(NYSE: BS)") end if %>; and WAL-MART <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WMT)") else Response.Write("(NYSE: WMT)") end if %> would move into the location vacated by WOOLWORTH <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: Z)") else Response.Write("(NYSE: Z)") end if %>. The changes were designed to lend greater weight to technology, health care, and finance, three increasingly important sectors of the U.S. economy. The immediate impetus for the update effort was Westinghouse's decision to spin off its industrial operations and become a pure play broadcaster within the next few months. With ABC and NBC already part of the Dow by way of Disney and General Electric, respectively, a new Westinghouse centered around the CBS network was expendable. Once the Journal editors began looking to make one change, others came up. "It is a process that we take very seriously," said Jim Hyatt, statistics editor at the Journal and one of the editors involved in the decision. "We don't do it very often because we think that maintaining continuity is one of the important attributes of the average. We spend a good deal of time looking at possible candidates and analyzing how a change would affect the makeup of the Dow in terms of properly representing major parts of US industry." The planned Westinghouse spin-off "made it more necessary to look closer" at the Dow, Hyatt said. "Since you don't change very often, if you're going to change one, you certainly want to look at all of them." Travelers Group, the financial services giant, is actually making a return to the Dow. The packaging manufacturer American Can Co. entered the index in 1916 and eventually evolved into Primerica, a brokerage and commercial lending institution. The company was part of the average until 1991, when it was ousted along with two other stocks in the last shakeup of the index. Primerica then bought Travelers Insurance and changed its name to Travelers Group. With Exxon and Chevron already Dow components, Texaco was expendable, particularly since energy has become somewhat less important in an information economy run on computers. Hewlett-Packard nicely fits the tech niche both because it's got a diversified product line, and, perhaps more important, it's traded on the New York Stock Exchange (NYSE). Indeed, many have wondered why high-tech bellwethers Intel and Microsoft haven't received a Dow invitation. "I don't think we've discussed that in public," Hyatt said. "We've always preferred the NYSE closes. That's been our policy on the industrial average. Now it is true that we have a Nasdaq issue on the transportation [average], but that's partly lack of transportation issues on the NYSE. I don't think we can go into what we discussed that we haven't announced." He did add, however, that the Journal editors felt Hewlett-Packard offered "a wide piece" of the computer-related economy. "After all, the kind of equipment they produce is computer-based and computer-oriented and in some ways cuts across a wide variety of that part of industry." O'Shaughnessy, president of O'Shaughnessy Capital Management and author of the recent business bestseller What Works on Wall Street, said he thought the Journal's preference for NYSE issues is "just a tradition and a mindset, frankly. Dow Jones is the keeper of an over hundred year old index, and there's a lot of tradition in that. It's really remarkable how closely the Dow has paralleled the overall larger market, the S&P and the other indexes. So I think at Dow Jones they have that mindset: to be part of the bluest of blue chip indexes, you've got to be traded on the NYSE." Still, he says, "I certainly think they should have been more willing to look at an Intel or a Microsoft. If you want a prediction: Microsoft or Intel moves to the Big Board, they'll be moved into the Dow 30 like that." The two other changes were no-brainers. Both Bethlehem Steel and Woolworth have fallen on difficult times and even canceled their dividends, excluding them from the various Beating the Dow formulas popularized by money manager Michael O'Higgins and practiced by the likes of O'Shaughnessy and Fools everywhere. Wal-Mart has eaten every other retailer's lunch, so they might as well sit at the counter once occupied by Woolworth. And with health care accounting for about a seventh of the nation's economy, the addition of the pharmaceutical giant Johnson & Johnson updates the average for a new era. On the other hand, the recent changes once again remind us of the arbitrary aspect of this index that investors typically take for granted. For one thing, any index can rocket forward if you're allowed to knock out the laggards. In other contexts, economists refer to this problem as a "survivor bias" that makes the overall results appear better than they should otherwise be. Of course, the index would have perished long ago without such constant revisions. In 1884, Charles H. Dow came up with the first list of 11 actively traded stocks, including nine railroads, and published them in the Customer's Afternoon Letter, a forerunner to the Journal. Dow's list went through three more permutations until his fledgling Dow Jones & Company came out with the first real version of the industrial index in May of 1886, a twelve stock average that still consisted of 10 railroads. Over the next three months, the average promptly lost a quarter of its value, dipping to an all-time low of 28.48. The DJIA continued to be updated on a frequent basis, both before and after the Journal expanded the average to 30 industrials in October of 1928, just a year before the great crash. The Dow's current roster of blue chips has been a long time under development. Eastman Kodak was added to the index in 1930, AT&T in 1939, International Paper in 1956, Merck in 1979, Philip Morris and McDonald's in 1985, Boeing not until 1987. Coca-Cola made it into the DJIA in 1932, only to get the boot three years later. It then spent half a decade in the wilderness, so to speak, before rejoining the Dow in 1987. IBM joined the list in 1932, was traded for AT&T seven years later, then rejoined the team in 1979, when it was the market's bellwether stock. The 1991 changes saw Caterpillar, Walt Disney, and J.P. Morgan enter the average while the ill-fated Navistar and the restructured USX were ousted and Primerica given a vacation. Such a history of change, though, leads one to ponder some provocative what-if scenarios. According to O'Shaughnessy, the DJIA would already have broken 8,000 if the four recent additions had joined the index in 1991. Yet Primerica is far from the only or most dramatic Dow stock to be ousted from the index only to return later. "What's really fascinating to look at is the early '30s," O'Shaughnessy said. "In the early '30s, Coca-Cola and IBM were both in the Dow and were thrown out until, in IBM's case, 1979 and in Coca-Cola's case, the mid-'80s. Had those two stocks simply been retained in the Dow, the Dow would be at like 10,000 now." To entertain such possibilities is to travel in the realm of an alternative universe. If the market looks toppy at 7,000, what if it were well over 10,000 instead? Would Greenspan need a new straightjacket? Or would we long-ago have suffered a wave of interest rate hikes that sent the economy into recession and kept the Dow from pushing much above 8,500? Of course, at least in theory, the market capitalization of IBM, Coca-Cola, or the entire Dow 30 would be exactly the same as it is now. Nothing would be different except maybe our perception. But would we actually feel more irrationally exuberant if the index's numbers were that much bigger? Or even more scary, would those Eliot Wave theorists somehow then make sense? ("Look! We've just been using the wrong numbers.") In addition to such historical conundrums, it's worth adding some numerical ones. Calculating the DJIA may seem like black magic, but there is a relatively simple formula. As a price-weighted average, the index could once have been calculated by adding up the total stock price of the Dow stocks and dividing by the number of stocks in the index. But due to splits, spin-offs, and the component changes, the divisor has itself undergone countless divisions. Richard J. Stillman offers a useful explanation of the issue in his 1986 history of the Dow. Assume, for example, that the index consisted of merely three stocks trading at $180, $120, and $60 per share, respectively. One could easily add up the numbers ($360) and divide by three to get an average of $120. But if the $180 stock split 2-for-1, the total would add up to just $270 now ($90 + $120 + $60), even though the real value of the stocks remained exactly the same. To solve this dilemma, one must divide the total stock price of the Dow components by some number that will make the equation equal the index value before the split ($270 divided by X equals $120). In this case, the divisor would be 2.25. It's easy to see that, over time, the divisor gets smaller and smaller. Since 1986, in fact, the divisor has actually been a multiplier. Prior to the recent component swaps, the divisor was 0.32481605, which meant that every one dollar change in a Dow component was worth a 3.0787 point change in the Dow. In other words, a $4 per share increase in IBM would have give a better than 12 point boost to the DJIA. Since the additions have higher prices, overall, than the stocks being replaced, the recent change actually raised the divisor to 0.33098002, slightly reducing the multiplier effect. The S&P 500 index is weighted by market capitalization. That's why strong growth by the largest companies has an enormous impact on that index. If the top 50 or so companies in that index perform well, it's virtually guaranteed that the index will move higher regardless of how the others fare. It's for this reason that the S&P can offer a somewhat distorted view of the market's overall strength. On the other hand, gains in the S&P represent a proportionate increase in the value of corporate America's top companies. There are several peculiarities to a price-weighted average like the Dow. For one thing, a 10% increase in a higher-priced stock will actually pump up the index more than a similar increase in a lower-priced stock. A 10% increase in AT&T, for example, would boost the average by just over 10 points (3.5 x the multiplier) whereas a 10% jump in IBM's stock would add more than 42 points to the index (14 x the multiplier). This becomes even more peculiar when you realize that were IBM to split 2-for-1 so that it traded around $70 a share, the identical 10% price appreciation would now be worth only about 21 points (7 x the multiplier) to the Dow. Of course, the divisor would be changed by the IBM stock split, but that change wouldn't be enough to compensate for the specific alteration in the pricing of IBM. In theory, the whole process works itself out over time. Changes in higher-priced shares impact the index more, but lower priced shares tend to have greater percentage changes and to rise more quickly, all other things being equal. Still, the index could theoretically jump 50% without the overall market capitalization increasing by even half that amount if splits didn't constantly cut down the impact of market highflyers. The Dow, for example, could leap from 7,000 to 10,500 if one issue soared by about 1137 points, based on the old multiplier. If IBM suddenly captured all of the world's computer market and the shares jumped from $143 to $1280, its market capitalization would go from around $73 billion to $657 billion. Even so, this $584 billion increase in IBM would amount to just a 40% boost in the DJIA's recent $1.456 trillion market cap. Caterpillar provides an even more dramatic example since its market cap is currently only $15.5 billion. If the company's tractors suddenly took over the world and the stock soared from $81 to $1218, the DJIA would turn in a blistering 50% gain even though overall market cap for the Dow components would have risen merely 15%, as a 15-fold boost in Caterpillar shares would add only $217 billion to its market cap. This is all mere esoterica, however. As nearly everyone agrees, the Dow has more than held its own as a leading index of American business. The more interesting question is how the recent substitutions are likely to effect the Dow and the investment strategies built up around the index. Will the addition of stronger companies make it easier for the Dow to crack 8,000? Do the Beating the Dow strategies hold up? "I don't think it's going to matter at all," O'Shaughnessy said. "I studied the Dow back to 1928. Over those years, there were innumerable changes made to the 30 stocks that were in the Dow. The Dogs of the Dow strategy continued to work throughout that time period. Stocks came in and went out, and it doesn't too much matter." He said the index has taken on more of a growth profile in recent years with the addition of Coca-Cola, Disney, and other companies that don't fall prey to the traditional business cycle. The new additions continue the move away from such industrial cyclical issues. But according to O'Shaughnessy, "I don't necessarily think that's a bad thing." He said the addition of such companies would "absolutely" strengthen the Dow's performance and "certainly could" improve the Dogs of the Dow strategy, the ten-stock version of Beating the Dow. "Every time a strong company gets put in the Dow, I think it's a good thing because ultimately, every company has its cycles." The Fool's own Robert Sheard (MF Dowman), commenting in his column last week, agreed that the changes seem like good ones that will make the DJIA more accurately reflect America's changing economy. He also noted that the changes had little effect on the Dow investment approach. Texaco would now be replaced in the list of top-ten yielders by Dupont. On the other hand, Michael O'Higgins, president of O'Higgins Asset Management and author of Beating the Dow, is less sanguine about the Dow approach and the overall market. "I think [the changes] will make a great deal of difference because the components that are being replaced are generally of a more cyclical nature. And I think it will hurt the ability of this program to work because you're getting much more homogeneity in the Dow in terms of all kinds of well-capitalized, 'growthie' type companies and away from the historical, cyclical bent of the Dow, which has been diminishing in recent years. This is putting another major dent in the cyclicality of the Dow components." As a result, he thinks the Dogs of the Dow strategy will be hurt. "The major ingredient in this approach is that you have companies that are very susceptible to the business cycle, kind of basic industrial companies. So these are the ones that tend to get in trouble in bad times. They also tend to be more leveraged. So they either do very well or very poorly. Their fortunes vary a great deal." To the degree that the Dow moves away from its basic industry character, he said, "I think you'll have less divergence in the performance of individual Dow components. I think you'll get more homogeneity than you had in the past." And that will mean less opportunity for investors looking to buy blue chips on the cheap. Rogue asked if O'Higgins had a new strategy to work around this problem. "At the moment? Yeah. I wouldn't own any stocks," he said. "To me, the bond market is much more attractive than the stock market." Indeed, O'Higgins falls very much in the camp of Warren Buffett, who last weekend indicated in a letter to Berkshire Hathaway shareholders that investors were very likely overpaying for all stocks. "Anybody who knows financial history has to be bearish," O'Higgins said. "Only those people, perhaps like yourself or the Gardner brothers, who haven't been around long enough to have been through some market cycles and haven't studied financial history, or honestly believe this malarkey that this is truly a new era" could be anything but bearish. "If you've done your homework, you have to conclude that stocks are at the most overvalued level in history. I'm unfortunately among that group." On the other hand, both Buffett and O'Higgins have been wrong in their predictions before. In fact, Buffett has even said that the best thing about stock prognosticators is that they make fortune-tellers look good. If it seems presumptuous to argue with such experts, it also seems a little preposterous to argue that all stocks are overvalued. Indeed, part of the problem with both the DJIA and the S&P 500 is that they allow commentators to make sweeping assumptions about "the market" based on the performance of a relative handful of stocks. Clearly, all investors should be interested in how these corporate giants are faring. The DJIA does allow us is a quick snapshot of the market's overall strength. And that snapshot can be as striking as a fashion spread, even if the models have changed innumerable times over the years. Still, the market is always and ever an amalgamation of the thousand of markets for individual issues. Whether the Dow or the S&P 500 can tell us much about those specific markets is an altogether different issue. --Louis Corrigan (RgeSeymour) (c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool.