The Dow Is a Dinosaur
Investors should ignore this myopic market measure and focus on better metrics
Jan. 12, 2011, 7:10 am EST | By Jim Woods
At the risk of committing heresy, it’s time investors stop worrying about where the Dow Jones Industrial Average is trading. In fact, it’s high time we ignored the Dow entirely.
Why? Because the Dow is an anachronism of a bygone era. Its constituent companies are less than representative of the real market, and more recently, its stodgy mix of components has failed to keep pace with more broad-based market indices such as the S&P 500 and the Nasdaq.
This last point was brought to my attention quite nicely by a recent post on the blog Crossing Wall Street. The site, run by well-known financial blogger Eddy Elfenbein, pointed out via a simple price chart how the Dow has essentially missed the rally that took place since August. I’ve taken Eddy’s keen observation, which points out how the Dow has lagged the S&P 500, and added the even better-performing Nasdaq Composite Index to the mix. I’ve also expanded the chart to include the last six months.
As you can see, the chart below tells the tale of an index that, while still posting laudable gains, has fallen well behind its bigger-breadth brethren.Here we see the Dow (blue line) is up about 12.5% over the past six months. Certainly, this can be considered outstanding performance. Yet from a relative viewpoint, the S&P 500 (red line) and the Nasdaq (black line) have left it in the dust. The S&P 500 is up about 16% over the same time period, and the Nasdaq is up over 20%. So, in the race for the best bang for your investment buck, at least over the past six months, the Dow has been the slowest of the three major market horses.
Why has the Dow failed to keep pace? Perhaps one reason has to do with the Dow’s long and storied history. The Dow Jones Industrial Average was the brainchild of the great Charles Dow, a true Wall Street pioneer. He created his famous index back in 1896 as a way to accurately measure the direction of the biggest industrial stocks. Back then the Dow had only 12 members, but in 1928 the measure was expanded to include 30 companies — a number it’s been stuck at ever since.
Arguably, this lack of representation in a market with as many listings as the current market is one big reason why the Dow is no longer a good lens with which to view the wider equity picture. And though the companies that comprise the Dow are rotated periodically, they are done so at the discretion of editors at The Wall Street Journal. This editorial subjectivity when it comes to selecting Dow components could also be one reason why this isn’t a very true measure of stocks.
Many truly representative companies exist out there with huge market capitalization, companies such as Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) — both big market bellwethers and which are not currently on the Dow. Of course, both of these stocks can be found on the S&P 500 and on the Nasdaq.
Journal editors have, of course, reshuffled the Dow’s deck in recent years. In 2008, AIG (NYSE:AIG) was booted out of the Dow, and just a few months later in 2009 General Motors (NYSE:GM) and Citigroup (NYSE:C) were ousted from the index. These three former components were replaced by Kraft (NYSE:KFT), Cisco (NASDAQ:CSCO) and Travelers (NYSE:TRV), respectively.
But the real issue isn’t willingness to change, or the fact that some of the biggest market-cap bellwethers are absent from the average. The real reason why investors need to consider the Dow a dinosaur is because it’s just not a real true measure of the market’s performance — and the constant monitoring of its price isn’t going to alter that.
If you want a more accurate feel of how well the market is doing, ignore the Dow and follow the S&P 500 and Nasdaq.
At the time of publication, Jim Woods held no positions in any of the above mentioned securities.
