The Dow Jones Industrial Average hit an all-time high this week. You may have heard this – nearly everywhere, actually, with references to "party hats" and "confetti" and the like.
Where? On the trading floors, in the halls of august investment houses? No, not really: No one deeply involved in the markets, outside of the folks at Dow Jones, really cares about the Dow or its record.
Why? Here are five reasons I hate the Dow and all the coverage it gets:
It's a "blue-chip" index that's missing many of the blue chips
From its beginning in 1896 as an "industrial" average that left out all the railroads, the Dow has struggled to include the big companies that truly represent the U.S. economy.
Are the 30 stocks in the Dow today the biggest companies in the U.S.? No; three of the four biggest, by value – Apple Inc., Google Inc. and Berkshire Hathaway Inc. – aren't part of it. There are nearly as many $100-billion companies that are not in the Dow (13) than in it (19).
(Read more on ROB Insight.)
There's no clear criteria for inclusion
Standard & Poor's and the folks who put together the Russell indexes are meticulous about their methodology. Here's what Dow Jones says about how a company gets into the world's most famous index:
While stock selection is not governed by quantitative rules, a stock typically is added to The Dow® only if the company has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors. Maintaining adequate sector representation within the indices is also a consideration in the selection process.
The stocks still underperform
That's a lot of latitude to pick and choose among America's corporate titans for inclusion. And yet, the stocks that make the Dow often underperform their peers.
In this article in The Motley Fool, Alex Planes notes that five years ago the Dow dropped Altria and Honeywell for Bank of America and Chevron. An investor who put $1,000 into the additions would have wound up with $957 five years later; buying the deletions would have yielded $1,779.
Mr. Planes says that from 1997 through early 2005, during which time the Dow replaced 11 stocks, additions lost an average of 2.6 per cent each, while deletions gained 2.8 per cent apiece.
Certainly, the primary goal of an index isn't to pick winning stocks, per se; but if the criteria are so loose as to simply tap companies with "excellent reputations," why not select ones that will beat the market?
The index is price-weighted
The real reason the Dow doesn't include Apple and Google, with their share prices in the hundreds of dollars, and Berkshire Hathaway, with Class "A" shares above $150,000 apiece, is that it's a price-weighted index.
Indexes have to weight their individual members somehow; most, like the S&P 500, choose the companies' market capitalization. When this is done, only rarely can a company have an outsize impact on an index.
Instead, the Dow weights companies by their share prices, which is an arbitrary measure; a $10 stock with $1 in earnings is priced similarly to a $100 stock with $10 in earnings. But price-weighting gives outsize influence to the latter.
Much was said about Apple providing much of the growth in the value of the S&P 500 as its market capitalization swelled to make it the world's most valuable company. But S&P's Howard Silverblatt notes that Apple and Exxon each represent less than 3 per cent of the S&P 500's performance; IBM, which is now over $200 per share, is more than 11 per cent of the Dow. (Chevron, a $100 stock, is more than 6 per cent.)
In order to account for stock splits and other transactions, Dow Jones uses a divisor that is currently 0.130216081. Easy-peasy.
It doesn't really reflect the U.S. markets
When the Dow started in 1896, it had 12 stocks, which was probably a lot better representation of the markets at the time. Today, there are more than 5,000 publicly traded companies in the United States.
The S&P 500 measures large-capitalization stocks; The Russell 3,000 runs through mid-caps into the small. And the little-known Wilshire 5,000 Total Market Index captures nearly all of the publicly traded stocks in America.
Dow Jones likes to say the Dow Jones Industrial Average has an exceptionally high correlation with both the Dow Jones Total Market Index and the S&P 500.
Which just raises the question: Why do we even need it anymore?
(Disclosure: The author was an employee of Dow Jones for six months, working in a bureau of the Wall Street Journal, before getting laid off as the tech bubble burst. He disliked the Dow before that, though.)
READERS: What else is wrong with the Dow Jones Industrial Average? Does it have any redeeming features? Talk it out in the comments.