Is the Dow still relevant in the 21st Century?
Resilience, time after time
Formed all the way back in the late 1800s, the Dow Jones Industrial Average (DJIA) is considered one of the key benchmark indexes for the US stock market. Such is its prominence, the Dow is regularly viewed as a lead indicator for global markets as well.
Despite its long history, the Dow as it is colloquially known, is not the oldest US market index. In fact, that honour falls to its peer, the Dow Jones Transportation Average. The DJIA originally measured the performance of heavy-industry stocks that were prominent around the turn of the 20th century and the years thereafter. Today, the Dow tracks 30 large companies listed on the NYSE and NASDAQ.
Throughout its history, the Dow has displayed remarkable resilience in recovering from economic turmoil. The index lost nearly 90% of its value during the Great Depression when it slumped to just 41.22 points in 1932. It also lost nearly 30% in 1962 amid the Cuban missile crisis, dived 45% during the 1970s recession, and plummeted over 50% in the midst of the GFC.
Within five years of its pre-GFC peak, however, the Dow reclaimed its former high. Over the last 40 years, the DJIA has increased by more than 2700%. Since 2015 this growth has moderated somewhat, with the index growing 35.8%, compared with over 80% for the NASDAQ. Nonetheless, the Dow posted one all-time high after another before peaking at 29,551.42 in February 12, 2020.
For all its resilience, however, including throughout COVID-19, a series of shortfalls with the index give rise to one key question. Is the Dow Jones Industrial Average still relevant in this day and age?
The Dow’s unique construction
Unlike the other key benchmarks used to track the US stock market, the Dow does not have any specific criteria for stock selection. Generally speaking, the companies must be large reputable businesses, with the S&P Dow Jones Indices tasked with selecting 30 stocks of their choice, which are then ranked based on their share prices.
Despite what many investors think, the 30 stocks are not the largest companies across the market. Furthermore, when one company is removed from the Dow, there is little visibility as to which stock will replace that company.
The value of the Dow is determined through the price-weighted movements of its constituents rather than the market caps of each company. The price of one share in each stock is tallied together before a ‘divisor’ is applied, currently approximately 0.1458, which normalises the impact of stock splits or other corporate events that change the capital structure of a stock.
Whereas the Dow once included stocks relating to cotton, steel, tobacco, rubber and numerous other heavy-industry sectors, today’s line-up is vastly different. In fact, today’s group of companies is far more diversified. It features the likes of McDonald’s (NYSE: MCD), Boeing (NYSE: BA), Goldman Sachs (NYSE: GS), Visa (NYSE: V), Apple (NASDAQ: APPL), Walt Disney (NYSE: DIS) and Microsoft (NASDAQ: MSFT), to name a few.
A benchmark no longer fit for purpose
Although much of the investment community looks to the Dow Jones for a gauge of strength across financial markets, the index arguably holds far less relevance in today’s system than in years gone by.
In coming to this view, it’s important to realise the societal changes that are lending themselves to support the need for a more reliable gauge of the market. The Dow was established to track industry-heavy stocks that today, largely hold a diminished role in supporting the American economy. Meanwhile, technology is playing an ever-increasing role in driving innovation and supporting the economy.
Another shortfall concerns the methodology of the DJIA, which does not weigh its constituents by their respective market capitalisations or industry sizes. Instead, because the Dow is a price-weighted index, it means that higher-priced stocks hold more influence in driving the direction of the Dow than stocks with a lower price.
As an example, a $1 rise in a stock like Pfizer (NYSE: PFE), trading around US$37.50 and valued circa US$208bn, would only offset a $1 fall in a higher-priced stock such as UnitedHealth Group (NYSE: UNH), which is trading around US$290 and valued near US$275 billion. Even though the percentage increase and variation in the market cap for Pfizer would be much greater than the decline of UnitedHealth Group, this is not reflected in the index’s calculation.
Ultimately, such is the narrow focus of the DJIA – tracking the performance of just 30 hand-selected stocks – the Dow provides an incomplete and insufficient representation of the broader stock market. The index is neither comprehensive enough to cover the entire economy, nor focused adequately on the segments that are driving economic growth. The NASDAQ, while largely tech-oriented and catering for start-ups, tracks as many as 3,000-plus stocks. On the other hand, the S&P 500 provides a far more detailed picture of America’s leading companies beyond the Dow’s small list.
With all this in mind, it comes as no surprise that an increasing number of investors are turning to the NASDAQ as a key barometer for the ‘future’ economy, while the S&P 500 depicts the pillars of today’s economy. In the meantime, however, that won’t stop the Dow acting as a barometer for global markets - even if it has been one giant accident.
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With over 15 years of experience within the financial services industry, Mike possesses an outstanding acumen and extensive insight when it comes to global equity markets and a range of financial services products.