Special to The Recorder
As I sit at my office desk on an early Christmas Eve morning contemplating the subject of my next article, I see a news headline that reads "The Dow is only 7percent from its all time high."
I quickly respond audibly with, "Who cares!"
As I looked around my office to make sure no one heard me talking to myself, I immediately knew what I was going to submit to the Recorder.
Why do we still care so much about the Dow? Is it truly a good stock market barometer? Is the S&P 500 a better indicator?
Regardless of your choice of poison, any performance measure that changes literally every moment does not interest me particularly much. Please do not misunderstand me. I am interested in knowing the performance of the Dow Jones Industrial Average (DJIA) or the S&P 500, but a monthly report would be more acceptable.
Better yet, how about once a quarter?
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This constant highlighting on the day-to-day performance of the stock market needs to end. Will this ever happen? Of course not, but it does not stop me from ranting about the nonstop reminder of the market’s performance being one investor’s worst enemies. It often turns patient, disciplined, long-term investors into CNBC addicts and eventually market timers.
Instead of being an effective stock market index, the Dow & S&P 500 often become an anxiety-magnification mechanisms.
For most of us, the stock market, as we know it, is the Dow Jones Industrial Average (DJIA).
"So, what did the market do today?"
When people ask that question, they are most likely talking about the DJIA.
Any time there is important stock market news our minds involuntarily think Dow. Without question, the Dow is the most followed and commented upon index in the world.
However, is it the ultimate indicator of the pulse of the market? Frankly, there is little debate about which is the best benchmark among alleged experts. The professionals overwhelming use the S&P 500 when comparing returns to the stock market.
Nevertheless, the Dow remains the granddaddy of all stock indexes. Don’t believe me? Where did the S&P close yesterday? No idea? How about the Dow? Ah! Now we’re talking.
If you are like most investors, you may not know the precise number, but you probably know the Dow is around 13,200.
Why are we so fixated on the Dow when compared to other indices? To answer that question, I feel a brief history lesson is required. I promise not to get too technical as I run the chance that you will doze off and skip the rest of this important article.
The DJIA is a "price weighted" stock market index created by Wall Street Journal editor and Dow Jones & Company co-founder Charles Dow. It was founded in 1896. It is named after Dow and one of his business associates, statistician Edward Jones. When Mr. Dow launched the Dow it had just twelve stocks. He simply added up the share prices of each stock and divided by 12. Fast forward 117 years and the only significant difference in the formula is the total number of stocks (30) and the divisor (.130216081). The take-away here is that the Dow represents 30 blue chip companies and is price weighted (I will explain this shortly).
On the other hand, The S&P 500 is a "value weighted" stock market index based on stock prices of 500 top publicly traded American companies as determined by Standard and Poor’s index committee. Unlike its older brother, the S&P 500 is only 55 years old. The take away here is the S&P 500 represents 500 companies and it is "value weighted."
Now that we have a basic knowledge of the Dow vs. the S&P, let’s examine why it is noteworthy to understand the difference between a price weighted and value-weighted index.
The difference is essential to understand why many people believe the Dow is a meaningless market gauge and the S&P 500 should be the king of the hill. For example, a price-weighted index (Dow) weights the stocks with the highest price with the most importance.
Why do many argue this is a serious flaw? Let’s say IBM (The Dow’s highest priced stock at $195 share) declines 20 percent. It will pull the Dow down by a lot more than the same 20 percent decline for the Dow’s lowest price stock, Bank of America ($11 share).
Is this fair? Because IBM has a higher priced stock, should it receive more influence in the index? Alternately, a value-weighted index (S&P 500) gives more weight to the stock with the highest market value (what the company is worth). This seems more reasonable, doesn’t it?
Some investors, including the author, question whether the Dow still matters because it only represents 30 large US companies, whereas the S&P 500 index represents 500, not to mention the price weighted/dollar weighted issue. Nevertheless, The Dow remains the top dog among investors. Despite all its shortcomings, the Dow is still the most-watched indicator for stock market performance.
By the way, do you have any idea the performance of each index as of this writing for 2012? The Dow has increased about 9percent (dividends not included), while the S&P 500 advanced close to 15 percent. Hmm, which one should you compare your results?
Pick your poison. Is it the Dow or S&P 500?
I think John Maynard Keynes answers it best, "it’s not important to choose whom you think is the prettiest girl but whom the judges think is the prettiest girl."
The Dow is the prettiest girl! The truth of the matter is if you want to measure the true health of the stock market, follow the Wilshire 5000 index! Oh my!
Another poison? Does this have to be so confusing? Oh, yes!
After all, this is Wall Street! Happy Holidays, folks! Cheers!
Harry Pappas Jr. is Managing Director-Investments at Pappas Wealth Management Group/Wells Fargo Advisors in Ponte Vedra www.pappaswealthmanagementgroup. com