It Is the Most-Quoted Stock Index, but Is It the Best Market Barometer? Let’s Demystify . . . : The Dow Jones Industrial Average

In the realm of finance, there’s no term quite as widely used or as constantly quoted as the Dow .

To many, the Dow Jones industrial average--an index of just 30 stocks-- is the market. The stock market--composed of more than 6,700 issues--is the Dow. And the Dow has almost mystical qualities as an indicator of health and a forecaster of economic and political news.

Yet, in an economy where the majority of the nation’s workers provide services rather than assemble manufactured goods, some find our fascination with an industrial average puzzling. At the same time, many professionals question the Dow’s effectiveness as an indicator of the market as a whole.

Unquestionably, the Dow--which closed at 3,747.02 on Friday--has paralleled the nation’s good times and bad. From nearly 400 in 1929, it crashed to 45 in 1932 with the Depression, climbed back to 400 again by 1955 with the postwar boom, reached 1,000 for the first time in 1972, 2,000 in 1987 and 3,000 in 1991.

But the Dow, some brokers and analysts say, is too narrow and too susceptible to violent short-term swings. And the companies in it, they say, are no longer representative of the U.S. economy.

“The Dow Jones industrial average has become such an ingrained part of Wall Street’s culture that it’s hard to imagine getting through a day without mentioning it,” says Hugh Johnson, chief investment officer at First Albany Corp. in New York. “But as popular and fashionable as the Dow is, it’s just not used in serious research. It does not adequately represent what’s happening in the market.”

John Prestbo, markets editor at the Wall Street Journal, a Dow Jones & Co. subsidiary, and one of three editors who recommend changes in the index, is familiar with the criticisms but says there are no plans to change the index. Change would ruin one of the Dow’s finest qualities: the 66-year history that has made it the best-known and most widely quoted stock index in America. The Dow also doesn’t purport to be an economic flag, or even an indicator of overall market health, Prestbo says.

“The Dow is what it is. It does not purport to measure the entire stock market. It purports to measure 30 blue chip stocks,” he says. “What these people are saying is, ‘We wish the Dow were something else.’ I wish my grandfather was a millionaire.”

The Dow Jones industrial average traces its roots to 1884, when a financial journalist named Charles Henry Dow needed a way to communicate changes in overall market prices to his readers each afternoon.

He came up with an ingenious idea. Find a representative group of companies, add up the closing prices of one share of each company’s stock, then divide by the number of companies to create an average. It was a simple formula, capable of being calculated quickly by hand--a necessary ingredient in the 1800s.

He published this average each day to give investors an indication of market health--and a report card on how their investments fared relative to the average.

Dow started out with 11 stocks, mainly railroads. But in 1928, he expanded the list to include 30 industrial companies--the genesis of the Dow Jones industrial average.

Only two things about the Dow have changed over the last 66 years: 17 of the 30 original companies and the so-called divisor.

The editors at the Wall Street Journal substitute companies when original Dow index firms drastically change their business, merge or go bankrupt. Changes are not made lightly, because every effort is made to keep the index historically significant. But Prestbo says the right move is often obvious.

When General Foods was bought by Philip Morris, for instance, it naturally fell out of the Dow 30, replaced by Philip Morris. When International Harvester--once a big manufacturer of farm and construction equipment--restructured, changed its name and sold the bulk of its business, it was replaced by Caterpillar, currently the nation’s biggest manufacturer of farm equipment.

Because the index is so old and so well understood, it is an unparalleled communication device--capable of telegraphing significant market moves to everyone from Wall Street professionals to housewives.

At one time, the Dow was also used by professionals, who examine overall market trends to determine how and when to invest. But today, though professionals continue to quote the Dow, few use it in research.

“You need look no further than its composition,” says Joseph Wahed, chief economist at Wells Fargo & Co. in San Francisco. “About 80% of those working in this country are in service industries. About 80% of the Dow is manufacturing. We are not accurately represented in the Dow.”

Furthermore, with just 30 stocks, a strong move by one company can skew the index.

“It’s crazy,” says analyst Johnson. “The purpose of an index is to eliminate discussions about individual stocks and talk about stocks in general. With only 30 stocks in the index, the results of very few companies affect the outcome. That defeats the purpose.”

And then there’s the divisor.

When Charles Dow started out, he was dividing per-share closing prices by the number of shares. But over the years, companies changed and declared stock splits that would have skewed the index if the divisor hadn’t been adjusted. (Nothing changes when you split shares, giving each holder of a $100 share two $50 shares instead. But because the Dow index is based on per-share closing prices, the change could affect the value of the index.)

To neutralize the per-share-price effect of stock splits, the divisor is adjusted. The sum of the 30 Dow stocks is divided by this number. Simply put, as companies divide their shares, the divisor drops.

Currently the Dow companies’ closing prices are divided by 0.3861073.

That fractional divisor makes the market appear more volatile than it is, some maintain. Why? Once the divisor dropped below 1--that happened one infamous day in 1986--it became a multiplier, magnifying market moves, says Robert H. Stovall, president of Stovall/Twenty-First Advisers Inc. and an adjunct professor of finance at New York University’s Stern Graduate School of Business.

Consider what happens when each stock in the Dow 30 moves one point in the same direction. In 1928, this would have moved the index 1.8 points--30 divided by 16.67. In 1986, the same change would have moved the Dow 30 points. Today, that same move would cause the index to swing 77.68 points--30 divided by 0.3861073.

Of course, the Dow is much higher today than it was 10 years ago, and these point swings still indicate the same percentage change. Nonetheless, because newspapers and television broadcasts tend to report the point swings rather than the percentage change, some investors walk away with the idea that the stock market has become more volatile, says Stovall.

Even the New York Stock Exchange contributes to the illusion that the market is more volatile because of bigger point swings in the Dow. After the 1987 crash, when the Dow fell 508 points in one day, the NYSE instituted a series of “circuit breakers” to limit swings in the market. These breakers impose temporary limits on trading, presumably to slow volatility and give investors a chance to cool off and reassess.

One of the circuit breakers is triggered by the Dow gaining or losing 50 points from its previous close. In 1987, a 50-point move was far more significant than it is today. Nonetheless, the artificial break remains at the same spot. And an exchange spokesman says there’s currently no talk about changing it to accommodate the diminishing Dow divisor.

In fact, the market has been unusually stable in recent years. Investors who focus on the Dow simply must become accustomed to double-digit moves as the Dow divisor continues to drop, he says.

There’s one other numerical criticism of the Dow index: that it’s based on stock prices, not market value.

What’s the difference? Consider two hypothetical companies, both of equal size and value. For simplicity’s sake, we’ll say their market value--the value of all their outstanding shares--is $1 million. Company A has 1 million shares outstanding, so each share of stock sells for $1. But Company B has just 1,000 shares outstanding, so each share sells for $1,000.

With the Dow formula, Company B gets exponentially more weight in the index than Company A--even though both companies are equally important. That’s simply because the Dow is based on the closing price of one share of each stock.

If the $1 stock gained 10% in value, the market value of that company would jump to $1.1 million, but the index would move only 0.26 points. If the $1,000 stock gained 10%, it would move the index 259 points.

In reality, Company A and Company B don’t exist. But Caterpillar, which sells for $108 a share, has twice the Dow-moving weight as AT&T;, which sells for $55--despite the fact that AT&T; is six times as large and seven times as profitable.

Investors, nonetheless, need market indexes, experts say. In order to invest wisely, investors need a historic look at the performance of various types of investments. And they need a way to gauge whether they’re investing wisely on their own or if they need an adviser. If they’re using an adviser, they need a measurement that will grade that adviser’s advice. Indexes serve all those purposes.

But if not the Dow, to which index do you turn?

If you’ve got a diversified portfolio of U.S. stocks, mutual fund managers, market analysts and economists recommend the Standard & Poor’s 500, a market-value-weighted index of 500 U.S. companies.

What makes the S&P; so popular among market professionals is the math. It includes so many companies that it can’t be thrown off by fluctuations in just a few. Moreover, it’s based on market value, so our hypothetical Companies A and B would get exactly the same weight in the index, regardless of their share prices.

Although it includes just 500 stocks, those stocks appear to be highly representative of the entire market. How do you know? There is another index that measures the market value of every listed stock--the misnamed Wilshire 5,000, an index currently composed of 6,723 stocks and computed by Wilshire Associates in Santa Monica. Over the last 20 years, the movements of the Wilshire 5,000 and the S&P; 500 have deviated by only 0.01%, according to Ibbotson Associates, a Chicago-based market research and consulting firm.

It’s a telling indicator of economic health too. Generally speaking, strong movements in the S&P; index foretell recessions and recoveries that are between six months and one year in the future, according to Commerce Department economist Larry Moran.

“We are looking for series that accurately and consistently track economic cycles, both peaks and troughs,” he says. “We can’t have an index that bounces around, because all that noise makes it impossible to track economic cycles. We are not saying that the S&P; is generally a better index than the Dow. But for our purposes--for tracking economic cycles--it’s the better indicator.”

Movements in the S&P; 500 are considered a leading economic indicator, tracked by government economists since 1968.

But few people outside the rarefied world of Wall Street focus on the S&P.; And, though market professionals gauge their performance based on its figures, most can’t quote the index level at any given time.

Why? Opinions vary. Some say the Dow companies simply trade so constantly that the Dow index gives a more up-to-the-moment picture of market direction. Others say it’s simply familiarity. You quote the Dow and everybody knows what you’re talking about. You quote the S&P; and you’ll spend the rest of the afternoon explaining what it is.

Another faction believes that what some consider one of the S&P;’s main strengths--its willingness to change--is a weakness when it comes to public acceptance. S&P; traces the roots of its 500-share index to 1923. But over the years, the number of companies in the index, the industry representation and the frequency of calculation have changed several times.

S&P; started out tracking 233 stocks. But because this was before personal computers and sophisticated calculators, the index value was computed only once a week. When it was obvious that more up-to-date information was needed, S&P; culled its universe to 90 stocks, which was updated daily. The company continued to track the larger 233-share index on a weekly basis and added companies into the formula. There were 416 companies in 1941 and 500 companies in 1957: 425 industrials, 60 utilities and 15 railroads.

In 1976, the industry mix was changed to exclude some industrials and utilities and add more financial, transportation and “mid-cap” stocks. In 1988, the mix was changed again to “relax” the fixed structure that allowed only so many companies in each industry group. The advent of “merger mania” had created many hard-to-define conglomerates, S&P; said.

Notably, the 500 companies in the S&P; index are not necessarily the biggest companies in the nation. The index is constructed “bottom up” by industry group and is designed to mirror corporate America--so there are many relatively small companies included.

All of this makes the S&P; a great indicator of overall market--and economic--health. But it has made it a bit harder for individuals to understand the exact nature of the index.

Do you use it to gauge the performance of your big-company stocks? Small-company stocks? Or just to measure the value of your mutual funds?

The S&P; is particularly helpful to measure the performance of diversified equity mutual funds, professionals say.

But if you’re investing in small companies, growth funds or mid-cap companies--with sales ranging between $1 billion and $2 billion, the S&P; 500 can be misleading. Why? It’s weighted by market value. So big companies have far more weight in the index than do small companies.

In other words, all the little companies in the index could be doing great--or pushing up daisies--and the index would barely shift.

S&P; and other professionals argue that weighting an index by market value is the right way to go. But it means that investors in small companies need to watch another index, such as the Russell 2,000 or the Nasdaq composite, which are made up primarily of small growth companies.

That’s important because big companies and small companies react to market and economic news in somewhat different ways. Over time, all stock indexes tend to rise, reflecting growth in the overall economy. And, generally speaking, economic upheaval hurts all stocks, large and small. But growth companies are more volatile, swinging up with greater force in economic recoveries and plunging more steeply when the economy hits the skids, notes Mark W. Riepe, vice president of Ibbotson Associates.

For example, when the economy started sliding into recession in late 1990, the Dow industrial average fell 4.3% for the year and the S&P; 500 slid 6.6%. But the Nasdaq composite plunged 17.8%.

On the other hand, as the economy showed signs of life, the Nasdaq soared, posting far stronger gains than the big-company indexes.

How It Works

Thirty of the biggest, best-known American stocks make up the granddaddy of all market indexes: the Dow Jones industrial average. But as closely as the Dow is watched, few understand how it’s calculated. It isn’t the sum of prices of its component stocks. Instead, each stock’s contribution to the average is weighted by its per-share price. That means a small company can move the Dow more than a bigger company, if the smaller firm has few outstanding shares and a high-per share price. For example, AT&T; is six times bigger than Caterpillar and more than seven times as profitable. But Caterpillar, because it sells for double AT&T;’s share price, accounts for double the number of points in the Dow. This chart shows the 30 Dow stocks and their respective weights in the index as of Friday, July 29. Company: Points of the dow AT&T;: 141.48 Allied Signal: 99.06 Alcoa: 202.66 American Express: 68.63 Bethlehem Steel: 57.63 Boeing: 115.58 Caterpillar: 280.67 Chevron: 114.93 CocaCola: 114.93 Disney: 109.75 DuPont: 153.78 Eastman Kodak: 125.29 Exxon: 154.10 General Electric: 130.47 General Motors: 133.06 Goodyear: 92.27 IBM: 160.25 International Paper: 188.74 McDonalds: 70.25 Merck: 76.73 Minnesota Mining & Manufacturing: 137.59 J.P. Morgan: 163.17 Philip Morris: 142.45 Proctor & Gamble: 144.39 Sears: 122.37 Texaco: 164.46 Union Carbide: 73.17 United Technologies: 156.04 Westinghouse: 31.40 Woolworth: 39.17 Dow Total: 3764.50 * through July 29

Confusing Signals

Because the Dow is made up of just 30 stocks, a strong move by just one company can skew the index. Consider what happened on July 21, when IBM shares rocketed $6.50--or nearly 12%-- on the strength of a strong earnings report. Change in the Dow Jones average: +5.18 points Increase attributed to IBM: +16.83 points What would have happened to the average if IBM were excluded: -11.65 points

Experts say the Dow also exaggerates apparent market volatility. That’s because the “divisor”--the number by which Dow closing stock prices are divided to create the average--has shrunk over the years to less than 1. When you divide by a fraction, the result is a larger number. So the calculation amplifies the apparent size of market moves rather than moderating them. In past years when the divisor was 1 or greater, the math worked out differently. These figures show the impact over the years of a $1 gain in each Dow stock. Date: Impact of a $1-per-stock gain Oct., 1928: +1.8 points April, 1986: +30 points July, 1994: +77.68 points

Dueling Indexes

Market performance varies widely depending on the index you watch. The Dow Jones industrial average and the Standard & Poor’s 500 are both “big company” averages, for instance, but their results can differ greatly. When the Dow lost ground in 1984, the S&P; was up slightly. When the Dow posted a double-digit gain last year, the S&P; was up far more modestly. The NASDAQ composite index, which measures small-company stock performance, shows even bigger disparities.