Why we don’t love the DJIA (but are still happy about 15000)

Posted on Posted in Financial Blog

Last Tuesday, investors celebrated the Dow Jones Industrial Average (DJIA) closing at its all-time high (as well as its upward tear through the 15,000 resistance level). One week later and the US stock market has crept up even higher. While we are also happy about the current condition of the market, we think this is a good opportunity to set a few things straight about the DJIA index.

When mainstream media covers financial markets, they tend to quote the DJIA instead of the S&P 500. Perhaps it’s because the DJIA has been around since 1896, with the S&P 500 coming later in 1957. Maybe the DJIA being a larger number (15,182 today) makes its daily fluctuations seem more exciting than the S&P (1,647 today). Whatever the case may be, it turns out the DJIA is a far less accurate representation of US stock market performance than the S&P 500 for two equally important reasons:

(1)   The DJIA is composed of only 30 stocks, whereas the S&P 500 is a portfolio of 500 stocks (naturally) and therefore offers a far more accurate representation of the US market as a whole.

(2)   The DJIA is a price-weighted index, which means higher-priced stocks have greater influence on the average than lower-priced stocks, regardless of the size of the overall companies. A higher stock price does not always indicate a bigger firm (in terms of equity). The S&P 500, on the other hand, is a capitalization-weighted index. Each company’s relative weighting in the S&P is determined by the market value of its equity, known as its market capitalization (price per share x #shares outstanding).

It should be noted that the DJIA and S&P 500 usually correlate fairly closely with one another, especially over long periods of time, so we are not saying that the DJIA is not a fair representation of the US stock market. It’s just far less accurate than the S&P 500 mainly because of the way it is calculated. Here is an example to illustrate the advantages of a capitalization-weighted index over a price-weighted index.

Showing how capitalization-weighted and price-weighted indices move differently

For simplicity, let’s create a 2-stock index with McDonald’s (NYSE: MCD) and Cisco Systems (NASDAQ: CSCO), both constituents of the S&P 500 and the DJIA. Mickey D’s trades at roughly $101 while Cisco’s stock price is about $21, yet the market capitalization (size of the firm) of each firm is $101.4 billion and $110.53 billion, respectively. CSCO is $9.13B (9%) larger by market cap, but McDonald’s stock trades $80 higher. (How is this possible? Because MCD only has 1B shares of equity outstanding, while CSCO has 5.33B outstanding). Since our fictional MCD/CSCO index was just created today, the price-weighted and cap-weighted indexes both start at the same level of 100. If we think about it logically—our index is composed of two companies of roughly the same size, so if the index really represents the overall (2-stock) “market,” an X% increase in one stock and an equivalent –X% decrease in the other stock should not move the index very far, if at all.

SCENARIO: Cisco’s earnings come in above analysts’ estimates and the stock increases +10% from $21/sh to $23.1/sh. McDonald’s earnings come in below estimates and their stock decreases -10% from $101/sh to $90.1/sh.

Under this scenario, the capitalization-weighted index stays right at its current level of 100. The market cap of one stock increased by exactly 10% while the other decreased by -10%, so the current level is maintained. However, because the higher-priced (yet smaller company) stock fell by -$10.1 while the lower-priced (yet larger company) stock only increased by $2.10, the price-weighted index falls from 100 to 93.44. However, we established before that if this index were truly representative of the overall market, equal and opposite movements by two same-sized companies should not move the market hardly at all, let alone decrease the index value down -6.56%. This clearly demonstrates why price-weighted indexes are far less ineffective than cap-weighted indexes, and why US investors should look to the S&P 500 before the DJIA.