Gannon On Investing

This just in from the news desk...A pig just flew...hell is frozen over...and a honest to goodness chart on Gannon's website appeared today.

What does this portend? Well we must be headed for a disaster of biblical proportions..you know human sacrifice--dogs and cats living toghether. See http://imdb.com/title/tt0087332/quotes.

Great post.

How they calculate and scale companies going out against companies coming in?
Obviously business potential varies from company to company, so if they replaced all 30 components with 30 dot comes, we will obviously change the index completely.

How they go about this when they alter the index?

Geoff,
Another thought maybe the % size of the DOw as it relates to listings on the NYSE. When the orginal DOW (10 and then 30) were first listed I would not be suprised if % (either as a number or by total market cap.) was greater than it is today.

Amir,

I will do my best to answer your question by quoting from the Dow Jones Indexes website.

Component Selection:

"While there are no rules for component selection, a stock typically is added only if it has an excellent reputation, demonstrates sustained growth, is of interest to a large number of investors and accurately represents the sector(s) covered by the average."

"Unlike the DJTA and DJUA, which include only transportation and utilities stocks, the DJIA is not limited to traditionally defined industrial stocks. Instead, the index serves as a measure of the entire U.S. market, covering such diverse industries as financial services, technology, retail, entertainment and consumer goods."

Calculation:

"The Dow Jones averages are unique in that they are price weighted rather than market capitalization weighted. Their component weightings are therefore affected only by changes in the stocks' prices, in contrast with other indexes' weightings that are affected by both price changes and changes in the number of shares outstanding."

I didn't mention this part in my post, because I was focusing on "human" problems with the index, not bizarre relics of the past. Many people have frequently complained that the price weighting makes absolutely no sense; unfortunately, it is necessary, because people like to chart the Dow over very long periods of time. Many years ago, this was the method used to weight the components; so, it must remain the method, if the Dow is to be a historically relevant index.

"The mechanics of the first stock averages were dictated by the necessity of computing it with paper and pencil: Add up the prices and divide by the number of stocks. This application of grade-school arithmetic, while creative is hardly worthy of remembrance more than a century later."

Later, a divisor was added. It's boring and largely inconsequential, so I won't comment on it. However, it's worth noting the DJIA isn't technically an "average", because it uses this divisor.

Steven,

I'll do my best to answer your question, also using quotes. Your question could be the subject of a more detailed discussion; however, this blog may not be the best suited for such a discussion. I really focus on individual stocks, not averages. So, maybe a more "macro" oriented blog would like to take up this subject.

The short answer:

"The 30 stocks now in the Dow Jones Industrial Average are all major factors in their industries, and their stocks are widely held by individuals and institutional investors. The DJIA accounts for approximately 23.8% of the total U.S. market, as measured by the Dow Jones Wilshire 5000 Index, as of December 13, 2005."

There are a few points worth mentioning here. First, Dow stocks are "widely held by individuals and institutional investors". The "individual investors" part is the more interesting, because there are plenty of other stocks of interest to institutional investors, and other indexes could easily handle that better than the Dow.

However, there is a certain marketing brilliance behind combining well-known, big businesses in important industries with stocks of interest to individual investors. If you limit yourself to a group of 30 such stocks (which isn't too many to talk about individually) you have a memorable index. Is it a useful index? I don't know about that.

You could easily design a few separate, more useful indexes. For instance, you could create a group of widely held stocks. Ignore the size of the company, ignore the market cap, ignore the industry, and ignore institutional investors – just group together the "n" most widely held stocks and weight them equally. That might be interesting, and would give a better idea of the "pain" or "pleasure" of market movements for the average individual investor. What's really going on in individual accounts? The Dow doesn't really measure that.

Now, as for the economic significance of the Dow, that's a much more difficult topic. If you simply want a measure of the market as a whole, the Wilshire 5000 is a better index:

"The Dow Jones Wilshire 5000 Composite Index is the most comprehensive measure of the U.S. stock market. The benchmark is designed to represent the performance of all U.S.-headquartered equity securities with readily available price data."

"Two versions of the index are calculated: one weighted by full market capitalization and the other weighted by float-adjusted market capitalization. The full-market-cap version is intended as a "wealth" measure, representing the total dollar value of funds entering or leaving the U.S. equity markets. The float-adjusted version is meant to be a more realistic benchmark, because it reflects the shares of securities that are actually available to investors."

Like "The Big 10", the Wilshire 5000 is a catchy misnomer. The index includes more than 5,000 stocks.

Are there still problems with the Wilshire 5000? Yes. Again, it depends on what you want to measure:

1. Do you want to measure what the market looks like to the average investor?

2. Do you want to measure what the market looks like to the average dollar invested?

3. Or, do you want to measure the value of economic assets in the U.S.?

The Wilshire answers question #2 pretty well. Question #1 would be better answered by a specially designed index. The view of the market to the average investor isn't really comparable to the view of the market to the average dollar. Individuals don't have their assets distributed evenly across the equity issues available in the major public markets. A lot of individuals who have held every share they had six year ago are nowhere near where the Dow is today, because they own the wrong Dow stocks and they own very poor performing non-Dow stocks.

Here are two lists:

List A:

Eastman Kodak (EK)

General Motors (GM)

Intel (INTC)

Microsoft (MSFT)

Home Depot (HD)

List B:

Altria (MO)

Caterpillar (CAT)

United Technologies (UTX)

Boeing (BA)

Exxon Mobil (XOM)

Which did more people own in 2000, List A or List B? Which do more people own today? And, in 2000, which list did people think would perform better?

List A is the worst performing stocks since the last high; List B is the best performing stocks.

Other notable issues include Disney (DIS), McDonald's (MCD), and Coca-Cola (KO). These are the kinds of stocks people would love to buy and hold forever. They are sentimental favorites. They are also below where they were trading at the last high – although, they are about in the middle of the pack for the Dow stocks.

So, I'd have to say the Dow doesn't really measure the performance of individual investors' accounts at all. There's a selection bias for individuals that isn't reflected in the DJIA. Obviously, there are also some popular stocks that aren't part of the Dow.

Recently, internet stocks are the best example. Generally, they've performed miserably.

To reinforce the point, I'll include ANOTHER chart. Here's a chart of two indexes and two stocks.

The Indexes: Dow, NASDAQ

The Stocks: Cisco (CSCO), Berkshire Hathaway (BRK.B)

I choose Cisco and Berkshire, because they have roughly the same market cap today and are really, really big companies that aren't in the Dow.

The chart:

http://moneycentral.msn.com/investor/charts/chartdl.asp?Symbol=CSCO&ShowChtBt=Refresh+Chart&PT=8&CP=1&C5=1&C6=2000&C7=12&C8=2006&C9=2&CA=1&CC=1&CE=0&CompSyms=BRK.B&D5=0&D7=&D6=&D3=0

My point: the market looks a lot different if you planned to buy and hold Berkshire, Cisco, the NASDAQ, or the Dow at the last high for the Dow.

Unfortunately, when I think back about the people I know who had previously had no interest in the market and then started buying in 1998 and 1999, they didn't mention Berkshire. They did mention Cisco. They didn't mention the Dow. They did mention the NASDAQ.

While this unscientific study of mine is necessarily arbitrary and backward looking, I should point out that I refrained from mentioning stocks where the business itself turned out to be an utter failure. I picked a stock (Cisco) where if you bought all your shares in January 1997 or January 1998, you're about even with where you'd be if you'd bought shares in Berkshire in January '97 or '98 – (in both cases, you're whipping the indexes).

But, you had to buy in January of '97 or '98, not in January of '99 or 2000. That's the problem. So, in a lot of ways we aren't near the levels of 2000.

There's also one other point: the dollar's worth a whole lot less. Your stocks may be quoted at the same number of dollars, but they aren't exchangeable into the same house, college education, or blissful retirement. Those are the kinds of things your stocks are supposed to buy you.

So, we're really a lot farther from those crazy days than it first appears.

Most investors are six years closer to death – and none the richer.