Monday, January 26, 2009

Why the DOW is a Poor Measure of the Stock Market

There are some amazing free trading and investing resources on the internet. If you haven't read John Mauldin you're missing out on fairly frequent insights into the economy. I Mauldin's writings emailed to me whenever he posts something new.

Upside Trader has a weekly newsletter that is not posted on his blog. I've read it the last few weeks and have enjoyed it. He tends to analyze the overall market, putting forth his opinions on what signals and info to look for in the coming week.

This last weekend Upside Trader mentioned one of Mauldin's recent posts. He highlights something that I found curious last week--something that I was going to point out today after reading Mauldin's "Here Comes Tarp 3 and 4". Last week I was surprised when I oversaw CNBC. The ticker for the DOW and the S&P500 was showing something peculiar. The DOW was up ~.5% and the S&P500 was down ~.5%, or something similar. At the time I didn't understand what would cause the divergence; I thought both of the indices monitored similar influences in the stock market. I was wrong.

While the S&P500 is market cap weighted, the DOW is weighted based on the amount a single share costs. When I first heard that, it sort of flew over my head. But what it implies is definitely worth the effort it takes to understand. Here's an example: despite MSFT's larger market cap ($156 billion), IBM (market cap of $123 billion) has a greater influence on the DOW's price. This is because market cap has no influence on the price of the DOW. It is based on share price. MSFT's shares go for 17.63, significantly less than IBM's 91.60.

This really starts to make things look weird when you consider the price of some of the financials on the DOW. They are all very low (e.g. C is 3.33 and JPM is 24.50). Mauldin says all the financials and all of the automakers on the DOW could go to 0, yes zero, and it would have less affect on the price of the DOW than if IBM, all alone, were to go to zero. He adds GE as a financial.

Mauldin goes on to say that there is a tacit rule that anything that falls below $10 is replaced by something else. However, the uproar that replacing C with something else, would be tremendous. Can you imagine the effect it would have on the DOWs price to replace a failing bank with something with a little more perk?

If you want to read his full article, check it out here.

I've heard a lot about why the DOW doesn't matter. Hopefully you now understand that the S&P500 is a better barometer of the stock market (assuming you didn't already grasp that 500 companies would be a better sample than 30).

I'm beginning to wonder how the media may manipulate this divergence to boost the general public's stock market sentiment towards something more positive. Something to look out for, especially considering many, many people use the DOW and not the S&P500 as a measurement of the stock market's health.

No comments: