The Dow Approach
The Dow Approach
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FOOL GLOBAL WIRE LEXINGTON, Kentucky (January 22) -- Maybe it rubs me the wrong way because I share the American passion of rooting for the underdog against the favorite (unless, of course, the favorite is the Kentucky Wildcats, and then "crush the little guy!"). Maybe it rubs me the wrong way because it just doesn't make sense. Maybe I'm just digging for an issue for today's write-up. Who knows? But the index Wall Street affectionately calls "the Dow," or in an even more generic sense "the market," is broken and needs a fixin'. What? This venerable index of American business is flawed? Throw out the arguments that the allocation of the 30 stocks is way off -- why three major oils and no Intel <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: INTC)") else Response.Write("(NASDAQ: INTC)") end if %> or Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: MSFT)") else Response.Write("(NASDAQ: MSFT)") end if %>? Why Woolworth <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: Z)") else Response.Write("(NYSE: Z)") end if %> rather than Wal-Mart <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WMT)") else Response.Write("(NYSE: WMT)") end if %>? Let's look at something more fundamental to the way the index is calculated. The Dow is derived by simply adding all 30 stock prices together and then factoring in a floating divisor that the Dow Jones Company adjusts to account for things like spin-offs and stock splits. Sounds reasonable, right? Well, it's not, and here's why. Today's move in IBM <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IBM)") else Response.Write("(NYSE: IBM)") end if %> is the perfect example of why this is the wrong way to calculate the index if it really is intended as a measure of all 30 stocks. IBM dropped roughly 9 dollars a share today after analysts were disappointed in the company's revenues for last quarter. But on a stock trading at $168 and change, a $9 drop is only a 5.4% loss. Now compare that to a stock like Bethlehem Steel <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BS)") else Response.Write("(NYSE: BS)") end if %>, trading around $9 a share. For Bethlehem Steel to have the same overall impact on the Dow Jones Industrial Average that IBM had today, the stock would have to drop to zero, or double, one or the other. The same 5.4% move IBM experienced today would only equate to half a point for Bethlehem Steel, a move that wouldn't even cross the radar screen of the overall Dow index. Another problem with this price-weighting system is that it tends to lock in gains when high-priced companies split their stocks. For example, let's say Exxon <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: XON)") else Response.Write("(NYSE: XON)") end if %> rises from $50 to $100, and then splits 2-for-1. That $50 gain is reflected in the rising Dow index as Exxon climbs to $100. Then when XON splits, the Dow's divisor is adjusted so that the index remains the same. That locks in price gains because now, at $50 a share, Exxon's moves will affect the overall index only half as much as they did prior to the split. For example, let's say that right after the split, Exxon drops 10%. If that drop had occurred before the split, it would have meant a $10 haircut for the Dow average. But since it happened after the split and the adjustment to the divisor, the same exact loss for anyone holding the stock only cuts the Dow index by $5, locking in the gains for the index through the simple act of a stock split. The split immediately halves Exxon's influence on the Dow index. Make sense? Not to me either. So if this index is really supposed to be a measure of 30 representative stocks instead of half a dozen high-priced issues, it makes more sense to do away with the price weighting and measure percentage gains and losses equally for the 30 stocks, including dividends. When a Woolworth gains nearly 70% and it's only half as important as Merck's <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MRK)") else Response.Write("(NYSE: MRK)") end if %> 27% gain to the overall index, the index is busted. And tied to this busted index is an equally busted benchmark. Trading curb limits on the NYSE are imposed when the Dow moves 50 points, even though that move represents less than three-quarters of one percent on the index's value, and in fact can practically be triggered by a big move in a single high-priced stock like IBM today. In 1990, a 50-point move was nearly 2% of the Dow's value, a huge difference in volatility, I think you'll agree. And don't even get me started on why we still quote stock prices in fractions. Wait, who's that guy wearing a white jacket, pounding on my door? ... No, I don't want a vacation! ... Really? I get to make clay pots and draw pretty pictures? Well, okay. |
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