What Is The Deal With The Dow Jones, The Markets and the Economy?
December 4, 2019 Author: Tess Downing, MBA, CFP®, Complete View Financial
Today many investors loyally “listen” to the Dow Jones Industrial Average (DJIA) as a proxy for the financial markets broadly and in some cases even the economy. As a financial advisor, I often get asked, “What did the ‘Dow’ do today?” My typical answer, “I don’t know. I do not follow that index.” Although, I definitely understand this perspective as news outlets, water-cooler talk and even some advisors often quote the DJIA as a proxy for the market.
If you’re rushed for time, we’ll go ahead and spoil the story for you now: The Dow is not “the market,” nor even “a market,” and it is even more emphatically not the economy. If you have time to stay with us — and hopefully you do — we’ll explain.
A market, or exchange, is a marketplace (physical, electronic, or both) in which stocks are traded. The New York Stock Exchange is a physical place, located at 11 Wall Street in New York City, as well as an electronic exchange. The Nasdaq, founded in 1971, is an all-electronic exchange, and indeed most trading today across all markets takes place electronically. What stocks trade on a given exchange will vary through time as companies meet or cease meeting the various listing requirements, so even an exchange is not a monolithic representation of a particular basket of stocks.
What is the Dow?
The Dow Jones was created in 1896, made up at that time of 12 companies predominantly from the industrial sector (hence the name). Today it includes 30 stocks, which have changed over time in an attempt to reflect the evolving nature of the U.S. economy. The oldest current member, dating from 1928, is Exxon Mobil, and only two others (Procter & Gamble and United Technologies) were added before World War II. Three date from the 1970s, four from the 1980s, eight from the 1990s, and the remainder have been added since 2004. “Industrial” today is a misnomer given that Dow components include Disney, American Express, Verizon, Visa, and Goldman Sachs.
The first fact that may strike you about the Dow Jones is that it contains only 30 stocks. As large and significant as these companies may be — behemoths such as 3M, McDonald’s, WalMart, Microsoft, Coca-Cola, and Apple — how can they represent the totality of the U.S. financial markets, let alone its economy? Well, they can’t.
Another less-obvious flaw in the DJIA is that it is price-weighted. This means certain companies can produce an outsized impact on the index. For example, in March 2019 Boeing, at that time the largest component of the Dow Jones thanks to its share price of over $420, caused the Dow to underperform when its share price was hammered over the 737 MAX’s problems. Clearly, an index that suffers significantly as a result of one company’s tribulations is hardly representative of the broader market.
Every other major index is capitalization-weighted. The S&P 500 is a much better broad representation since it contains 500 stocks chosen, according to the SEC, for “market size, liquidity, and industry group representation.” The Wilshire 5000 Total Market Index includes “all U.S.-headquartered equity securities with readily available price data.” The Russell 2000, considered the thermometer of small business, uses the “2,000 smallest publicly traded U.S. companies.” The Nasdaq-100 leans, of course, toward technology stocks (although technically it is the “100 largest and most actively traded non-financial domestic and international securities” on the Nasdaq).
No Market Index is a representation of the US economy
To tackle the other fallacy, no market index, no market how broad or sophisticated, is a representation of the U.S. economy. While this might seem obvious, many investors — consciously or not — tend to equate the two. There are many reasons the economy and the markets are not the same; because you do probably have other things to do today, we will address only two.
First, the financial markets are affected by factors that have nothing to do with the economy, including herd mentality, irrational enthusiasm for or rejection of a particular stock or sector, and even the hidden impacts of automated algorithmic trading. If you want proof, look no further than MIS International. In early 1999, near the height of the dot-com mania, MIS was a penny stock which at that time had no actual business operations, let alone profits. It changed its name to Cosmoz.com and saw its stock price surge to $5; even after initial enthusiasm cooled, it still settled around $2. Our ancestors were no wiser, sadly; in the 1920s, the hot ticket was airplane-related companies, and a firm called Seaboard Airlines enjoyed similar investor enthusiasm for its stock. Only later did many of them discover that Seaboard was actually a renamed railroad company.
Stock Prices Have Little To Do With Actual Business Performance
A major contributor right now to record-breaking market indices is the amount of capital injected into the economy by the Federal Reserve (and other central banks around the world) combined with artificially low interest rates. That capital is chasing returns, and much of it has found its way into the financial markets. Consequently, stock prices in many cases have little to do with actual business performance. Corporate earnings have been lackluster, and only the money pumped into stock buybacks has boosted earnings per share.
Second, if anything the financial markets are often a leading indicator of the economy. That is, after all, fundamentally what professional money managers are paid to do: identify where stocks in general and specific companies in particular are headed and buy and sell accordingly. This is not a perfect correlation, especially not in the distorted environment in which we now find ourselves, but it can be informative.
What index to look at instead?
There are also specific indices that can be good economic indicators. One of the best know is the Dow Jones Transportation Average (which actually predates the DJIA). The rationale is that because both raw materials and finished goods have to be transported, a slowdown in the Dow Transports means economic activity is slowing. A related measure is the Baltic Dry Index, which rather than being a market index tracks the cost to move cargo by ship.
There are those who believe the Dow Transports can be used to time the market. We don’t recommend attempting market timing on this (or any other) basis. However, as a general barometer of economic health, it can be useful. In fact, what some might find ominous is the current (and widening) divergence between the DJIA and the Transports.
The Bottom Line
The financial markets, and by extension, your investments, are too complex to be summed up in a single number. You need a carefully planned strategy backed by a disciplined approach, and you should not be distracted by the Dow or any other index. After all, if the global financial markets could be accurately measured by a single number, we’d probably all be rich.
For more information about whether you should pay attention to the stock market or the economy, read here.