Dow Average Is Too Low by Some Standards

Never mind all that talk about the stock market being too high. The Dow Jones industrial average at 10,531 may be way too low.

That doesn’t mean the 30 stocks in the Dow average are attractively priced. It’s just that the best-known measure of U.S. stocks hasn’t captured the full effect of the eight-year bull market.

Why? Because the calculators of the Dow use what in the opinion of many economists and investors is an antiquated method that lowers a company’s weighting in the average when it splits its share price.

The 30-stock benchmark would be hovering near 13,000 if it were calculated by the method that makes sense to most professional investors, ignoring splits, according to money manager Robert S. Salomon Jr.

“The Dow would be much higher, and it would [reflect more] the way you and I manage our investments,” said Salomon, a principal in STI Investment Management.

The Dow, owned by Dow Jones & Co., is the simplest type of index, essentially an average of its companies’ stock prices. That means that J.P. Morgan & Co., with a stock price about $135 as of Tuesday, has about four and half times the impact on the Dow as Walt Disney Co., at about $30 a share--even though Morgan’s total market value is far less than Disney’s, $24 billion compared with $61 billion.

A company’s weight in the average drops when the company splits its stock, even though a split has no effect on underlying value.

IBM, the highest-priced Dow stock at about $221 a share, now carries the most weight. But after the company splits its stock 2 for 1 on Thursday, IBM will fall to fourth in importance.

Investors who own a portfolio of stocks that tracks the Dow will have to sell half of their IBM shares when the split occurs to match it.

“That is kind of an unusual strategy,” said Gus Sauter, who runs the $190-billion stock index investing unit at Vanguard Group. “It’s highly tax inefficient.”

This anomaly is the big reason Vanguard, the biggest manager of index mutual funds, doesn’t offer a fund linked to the Dow average, and why professional investors use the Standard & Poor’s 500 Index, which is weighted according to total market value, as their benchmark. The S&P; 500 also is a better reflection of how large-capitalization stock investors, on average, are doing.

Salomon went back to the end of 1995, a date he picked arbitrarily, and recalculated the index to see how it would have fared if companies’ weightings stayed the same after stock splits, in effect, keeping two McDonald’s shares in the index after the company split its stock 2 for 1 on March 8, for example.

By his calculation, the Dow average would have topped 10,000 in September 1997, rather than this last March 29, and would be about 13,000 now. Dow Jones should change the way it calculates the index so splits no longer affect a company’s weighting, said Salomon, a former partner at Salomon Bros. Inc. who’s spent 40 years in the investment business. However, that would make historical comparisons difficult.

There’s no doubt the Dow industrial average’s returns have lagged those of the S&P; 500 throughout the years. From 1968 to 1998, the Dow rose 873% versus 1,084% for the S&P; 500. (Since Jan. 1 of this year, the Dow has outperformed other indexes by a large margin, primarily because some of its higher-priced and cyclical stocks have performed particularly well.)

Charles H. Dow created the DJIA in 1896 and began printing it daily in the newspaper his company published, the Wall Street Journal. The average originally comprised 12 stocks and was expanded to 30 issues in 1928. Editors at the Journal, owned by Dow Jones, still oversee the benchmark.

Criticism about the way the Dow average is figured bothers no one at Dow Jones. “The purpose of the index is to tell you what direction the market’s going,” said John Prestbo, markets editor at the Wall Street Journal, who oversees the index.

He said the complaints come from institutional investors. Individuals, meanwhile, embrace the average, which contains about the same number of stocks, more or less, as a typical stock portfolio, he said.

But big investors, who rarely use the Dow for research or any other purpose, say the 30 stocks are not a broad enough sample, and the index lacks enough technology stocks to reflect today’s economy.

“It’s such a narrow index that to me it doesn’t represent the market, however calculated,” said J. Parsons, head of equity management and trading at Barclays Global Investors.