Don’t trust the Dow. It’s a liar
Today's Financial News - Posted February 19, 2009
Almost all casual investors trust the Dow Jones Industrial Average to tell the truth. Unfortunately, it has been lying to them for a long time. It is only going to get worse.
By Andrew Snyder, TodaysFinancialNews.com
Baltimore – (TFN): You cannot trust anybody on Wall Street these days, not even the Dow Jones index. The magical figure that is watched by investors all across the globe is lying to us.
The worse the nation’s financial crisis becomes, the less the index will tell the truth.
When the Dow Jones Industrial Average was created some 113 years ago, its newspaper-industry creators made a haunting mistake. They made the index price-weighted instead of value-weighted index. In other words, the higher a company’s share price, the more “pull” it has in the index.
As you should know, the Dow has thirty Blue Chip components. The companies the index monitors are supposed to be the bellwethers of their industries.
Right now, IBM (NYSE:IBM) gets the most weight (over 9%) due to its $88 share price.
On the opposite end of the spectrum, companies like General Motors (NYSE:GM) and Citigroup (NYSE:C) have very little weight, due to their respect share prices of just $2.02 and $2.50.
Unfortunately, the companies in the most danger of bankruptcy have the least amount of weight. In fact, the Washington Post reports, if these two companies see their shares go to zero due to bankruptcy or nationalization, the Dow would only mark a drop of 50 points.
That is an absurd notion considering the economic impact that sort of news would bring.
Index or popularity contest?
Adding even more “skewing” potential is the fact that the critical Dow’s managers have a tendency to swap positions in and out of the index. Most recently, they crossed out AIG (NYSE:AIG) and added Kraft (NYSE:KFT). Every substitution, no matter how closely related the companies, skews the indexes future movement.
The managers removed a highly indicative company with strong correlation to the current recession and added a recession-resistant company with a moderate share price and therefore a moderate weight.
With this kind of manipulation, while certainly not malicious, it is no wonder the index’s moves are hard to predict.
Wall Street has turned up its nose to the Dow Jones index for decades, yet it remains the most closely watched monitor of the equities market.
Investors need to be aware of this phenomenon. Sure, the Dow and the S&P 500 correlate over 95% of the time, but going forward that figure will likely fall as the S&P leads us out of this financial meltdown.
The Dow makes great dinner party conversation, but if you are serious about tracking the markets, you had better keep your eye on a much broader, value-based index like the S&P 500. Its action tells the real story on Wall Street.
Next Article: No Dust Bowl days for Whole Foods (WFMI)
Posted by Andrew Snyder · Filed Under News that Matters, US Stocks and Markets
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February 20th, 2009 at 12:12 am
It’s becoming more obvious that one must lie in order to steal. Madoff and Stanford are not the only ones. The 330-million-head sheep ranch exists not because the public is stupid, but because they’ve been lied to for so long. Today’s harsh reality is educating folks fast.