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Why Dow Jones Index Does Not Matter?

Dow Jones Index Sign On The Wall
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Dow Jones Index was created in 1896 as an indicator of how well the US economy was growing when 30 of its large publicly held companies did well during a standard trading session. Even today, the DJIA represents an average of the stocks of top 30 companies that are majorly considered to have an impact on the growth or decline of the US economy.

Just 30 out of the 4333 (as on June 2016) publicly traded companies and the number has come down from more than 8000 since 1996 due to various factors including the higher underwriting and registration costs, market volatility etc.

Apart from representing the 30 huge companies, higher DJIA index value does not represent growing personal income, GDP, lower unemployment rates or any economic indicator that reflects true growth.

More often, the DJIA has been fostered and reported as the primary indicator of the US economic growth whereas in reality it has got nothing to do with real growth but only to raise the demand of shares and hence their prices disregarding the actual worth of the company. If what doesn’t signify real growth grows for no good reasons, it is bound to hit the bottom.

History repeats itself. The DJIA indices rallied considerably before taking dips during both the Great Depression in 1929 and the Great Recession in 2008. The momentous rise of Dow Jones Index can be claimed to be a historical achievement but if the rise is not accompanied by real growth, it is a premonition that there is disaster awaiting ahead.

Thus, the rise in DJIA may sound promising at the moment, but it is also an alarming harbinger of what is lying ahead of us.

‘The Dow hit 20000. The Queen of England turned 90 last year. Both are round numbers. Neither carry any real significance..’

Greg McBride, Analyst, Bankrate in Jan 2017

 

DJIA 1929-Stock-Market-Crash-Daily-Chart-1 (thegreatrecession.info)

 

Graph showing the number of companies in the Dow Jones Index

Sources: thegreatrecession.info

The history of Dow Jones Industrial Average and some interesting facts

In 1882, Charles Dow, a Wall Street Journal editor, Edward Jones, a US statistician and Charles Bergstresser, an AMerican journalist founded the Dow Jones & Co. The Dow Jones Index then did not include any of the industrial stocks but 11 transportation companies including a steamship and a communication company.

Contrary to the popular belief, the Dow index appeared not in the Wall Street Journal but in its precursor, Customer’s Afternoon Letter, a two-pager financial bulletin.

The average stock value of the 11 transportation companies gradually became the transportation average and only on May 26, 1896, the Dow Jones & Co. split the average into two: transportation and industrial averages, in which the latter is known as DJIA.

Back then, the Dow Jones index was calculated as a simple arithmetic average by adding the stock prices of all the companies and dividing the value by 11. The method of calculation has evolved and has gone through nearly 53 changes over a period of more than 125 years.

Out of the 11 companies which were instrumental in deciding the prospects of the market and economy, only General Electric makes it to the list of 30 companies in the modern day Dow Jones Industrial Average. The list of companies changes and they are picked by the Wall Street Journal editors to make the average stay relevant as a measure of the the US economy.

Why is Dow Jones not very accurate?

The DJIA is not anymore the simple average of the 30 stock prices. The way the corporate stocks behaves has gone through structural changes like splits, dividends, spin-offs etc. and these factors were not considered during the initial days when the average was calculated. To adjust to these changes in stock prices and to offer an accurate average value, the sum of the stock prices are divided by Dow Divisor, an adjusted denominator.

For instance, the value of Dow Divisor was 16.67 in 1928 and on March 14, 2017 the value was 0.14602128057775. The value of Dow Divisor can be found here.

Adding to this inaccuracy, the DJIA is a price-weighted average, which means that the stock with the highest price is more significant than that with the lowest price in determining the index . A 1% change in a $100 stock is less significant than a 1% change in a $10 stock. These inaccuracies are not considered in the DJIA. Standard and Poor’s 500, an alternative to DJIA is market-cap weighted and is more accurate than the Dow Jones Index.

Despite all these inconsistencies, Dow Jones Industrial Average is one of the most reported indices that does not accurately reflect growth. It does not include Facebook, Amazon, and Google. The following are the 30 companies in the Dow Jones Index.

The 30 companies in the Dow Jones Index as of 2017

The 30 companies in the Dow Jones Index as of 2017

 

Featuted image Source: Politico.com

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