The Dow Jones Industrial Index is currently trading at all time highs.
In fact, it’s spent most of this week trading either side of 17,600 points.
Just a few weeks ago, resource analyst Jason Stevenson from Diggers & Drillers pointed out that the Dow is primed for the next leg of a bull market. He explained why this will happen at great length in Friday’s Money Morning this week.
A couple of weeks back, he told readers, ‘A sustained bounce, with momentum, above 17,195 points into late November would be a good indicator that the next phase of the bull market has begun.’
It’s the middle of November, and the Dow is more than 400 points higher than the bounce Jason was looking for. That said, even though Jason’s bullish on the Dow, he sees it making a minor correction that should start next week.
Free Reports:
Jason’s bullish prediction has stirred some office discussion.
The big question around the office has been if the Dow is even a relevant tool for investors anymore.
Way back in 1897, the Dow Jones Industrial Average was a balanced view of large cap stocks.
In other words, the productivity of the largest listed companies at a glance.
The reason why it’s called an industrial index was because it included the heavy industrial producers of the period.
But it’s no longer a measure of production.
Yet it is the deepest ongoing source of financial history. Through wars, politics, and financial crises, there has been the Dow to reflect upon. A monetary reaction to global events. A link that connects then to now.
It’s this history of the Dow that keeps many analysts referring back to it. We’ve been trained to find it useful.
There isn’t a news bulletin or financial website that doesn’t tell you where this index is.
But the problem is, the Dow isn’t a useful measure of the production of the US economy anymore. It’s not useful as a gauge of the broader market either.
Let me explain.
There’re two main reasons why the Dow isn’t an effective measure of the American economy. The way it’s calculated is outdated. You see, the Dow is a price weighted index.
This means the bigger the share price, the larger the weighting that company has in the index.
For example, the Visa Inc. [NYSE:VISA] share price is hovering around US$250 per share. As a result, it’s the largest constituent of the Dow, with a 9.19% influence on the index.
But this price weighting method undermines the more valuable companies within the index.
I’ll show you want I mean.
Take IBM Corp. [NYSE:IBM] and Microsoft [NASDAQ:MSFT] for instance.
Microsoft has a market capitalisation of US$402 billion. This is almost three times that of IBM’s US$161 billion.
However, Microsoft shares are trading around US$48 dollars. Whereas IBM’s share price is roughly US$161. This means that any move in IBM’s share price has three times the effect on the price of the Dow that Microsoft does.
Microsoft is arguably the more valuable and more relevant company of the two. Yet any stock price changes to Microsoft shares will have a lesser effect on the Dow.
Add to that the problem of stock splits. The Dow was set up in a time before stock splits and dividends. When you have a price weighting method, a 2 for 1 stock split causes all sorts of problems.
A stock split doesn’t change the value of a firm. And the fundamentals of the business haven’t changed either. But if a share price halves because of a split, the Dow would plummet.
To overcome this, the Dow Divisor was created. That is a mathematical solution to absorb the effects of a share split. Again, this is only a problem for price weighted indices.
Aside from unequal company weightings on the Dow, it’s the businesses themselves that prevent it being a true gauge of the broader economy.
The businesses that make up the Dow these days aren’t the producers driving a growing economy.
Instead, they’re companies that have passed the high growth stage. Mature firms that offer steady returns rather than speculative gains.
When you have mature companies filling a major index, it distorts the view of the broader market.
Jason agreed the Dow doesn’t reflect the broader US economy anymore. He believes the Dow is still important because it’s an indication of where the big money goes.
‘It tracks 30 of the leading company stock prices from different sectors. Many of these stocks would be held by large US pension funds and sovereign wealth funds. Therefore, I’d say that the Dow technical tracks the money market where the S&P 500 tracks the broader market.
‘Don’t get me wrong, the S&P 500 is important. But at the moment, in this market, the true players are the sovereign wealth firms and pension funds — these are the guys with money. That’s why the Dow is important to follow, and especially if it holds a large institutional shareholding which is likely.’
Jason also adds that the Dow hasn’t been caught up in the tech boom either. It’s made up of financial, industrial and retail companies. These companies haven’t had their share prices rise in a potential tech bubble, so perhaps they are more stable.
But I reckon this is another weakness for the Dow.
The Dow doesn’t cover the most innovative sector of the market. The reason for this is that stocks like Apple Inc. [NASDAQ:APPL], Amazon Inc. [NASDAQ:AMZN] and Google Inc. [NASDAQ:GOOG] would completely distort the Dow.
Apple would gobble up 20% of the index, Amazon 13% and Google almost 40%.
But by not covering three of the biggest and most innovative companies of the last decade, the DOW simply does not reflect the broader market, making it completely useless.
Leaving out the tech industry behemoths means the Dow only represents a partial section of the economy.
Jason might be right on this one. The Dow doesn’t reflect the broader market. But it very well could tell you where all the big market money is going.
Shae Smith +,
Editor, Money Weekend
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