Dow Jones Industrial Average Surpasses 40,000 Mark, Impact Debated

The stock index's peculiar methodology results in an uneven representation of component companies, with certain firms being overrepresented while others are underrepresented.

It has taken the Dow a little over seven years to double since it hit 20,000.

While the Dow Jones Industrial Average hitting 40,000 points for the first time may seem like a significant milestone, there are several reasons why it may not be as consequential as it appears:

1. The Dow is often criticized as a less meaningful index: Its methodology, which weights companies based on their stock prices rather than their market capitalization, can make it less representative of the overall market compared to indices like the S&P 500.
2. Limited information provided: With just 30 large, blue-chip companies included, the Dow may not offer a comprehensive view of the broader market's performance.
3. Limited financial impact: Given its small number of constituent companies and the relatively small amount of investment capital directly tied to it, the Dow's movements may not have a significant impact on the broader financial landscape.
4. Round numbers like 40,000 are arbitrary: They hold little intrinsic meaning in terms of market analysis, and focusing on them can distract from more meaningful metrics.

People perceive the significance of the Dow Jones Industrial Average (DJIA) primarily because influential news outlets assert its importance. Financial journalists also emphasize it as news because of the anticipated audience interest. Consequently, individuals believe in monitoring the Dow simply because it is widely perceived as significant by others. However, finding credible individuals who genuinely believe in its importance is a challenge. Let's delve into substantiating these claims.

Concerns Arise Over Accuracy of Approach

The Dow Jones Industrial Average (DJIA) is not technically an index but rather a price average, a groundbreaking concept introduced by Charles Dow in the late 19th century. Stocks included in the DJIA are weighted based on the price of one of their shares, rather than their total market capitalization. This methodology results in peculiar weightings, as illustrated by comparing the percentage weight of the 30 current Dow stocks with their weightings based on market capitalization. The disparities are remarkable.

There's legitimate concern regarding the dominance of tech platform stocks in mainstream cap-weighted indexes. Consequently, the underrepresentation of the three tech giants — Microsoft, Apple, and Amazon.com — in the Dow relative to their overall size might appear appealing.

However, the allocation of weightings in the Dow often seems illogical. Certain companies, such as UnitedHealth Group Inc and Goldman Sachs Group Inc, hold significant weightings due to high share prices, while others like Caterpillar Inc, The Home Depot Inc, Amgen Inc, and Boeing Co are also disproportionately represented. Conversely, Walmart Inc, with a market value exceeding $500 billion, is notably underrepresented. The lack of a discernible rationale behind these allocations undermines the index's credibility.

Indexes based on fundamental metrics like dividends, earnings, or revenues would make more sense. Assigning them equal weightings could potentially convey meaningful information. However, pricing stocks solely based on share prices appears futile.

Reevaluation Needed for Accurate Representation

At one juncture, the Dow Jones Industrial Average (DJIA) comprised leading companies across major industrial sectors. Once included, a company typically remained in the index unless it was acquired or faced bankruptcy. Being part of the Dow was esteemed as a mark of prestige, while being removed was considered a setback.

Presently, the selection of Dow members appears driven by an effort to align the index's performance closely with that of the S&P 500, the most influential benchmark in which substantial investments are tied. However, this approach has led to questionable decisions. For instance, Intel Corp., with a market capitalization of $136 billion, is included in the index, while Nvidia Corp., valued at $2.3 trillion, is not. Similarly, Chevron Corp., with a market value of $297 billion, represents the oil sector, whereas ExxonMobil Corp., valued at $528 billion, has been excluded.

Combining the issues of flawed methodology and questionable membership decisions, an analysis reveals the contributions of individual stocks to the DJIA since it surpassed 20,000 points in January 2017. While Apple Inc. alone accounted for over 3,000 of those points, the other major contributors form a peculiar assortment.

Moreover, several companies that detracted points from the DJIA over the past seven years have been removed from the index during that period. Notably, two longstanding members, ExxonMobil and General Electric Co., have been dropped, exacerbating the index's challenges.

Criticism Mounts Over Lack of Defined Guidelines

The Dow Jones Industrial Average (DJIA) lacks a fixed formula or standardized guideline for selecting companies to include. Instead, a selection committee wields broad discretion, often removing underperforming large companies from the index. However, this approach introduces survivorship bias, as indexes tend to represent successful companies, potentially leading to misleading conclusions.

In recent years, the discretionary powers of the selection committee have exacerbated the challenge of market timing. This is evident in decisions to drop notable companies like General Electric and ExxonMobil. General Electric was removed in 2018 amid its prolonged decline following Jack Welch's departure in 2000. ExxonMobil exited the index in the summer of 2020 during a period of low oil prices due to the pandemic. Despite their subsequent resurgence, their removal from the DJIA crystallized previous losses, causing the index to miss out on potential gains.

The significant impact of discretionary decisions raises questions about the index's overall relevance. While the index committee is not tasked with selecting winning investments, their actions sometimes suggest otherwise. This phenomenon mirrors the challenges faced by active traders, often leading to suboptimal returns.

In essence, the discretionary nature of the DJIA's composition complicates its significance, particularly when critical decisions rest on a few individuals. This raises doubts about the index's value as a comprehensive market indicator.

Challenges in Motivating Action

In the age of passive investing, the biggest reason to follow stock indexes is that they have come to matter. Choices over which companies or countries to include in the most popular benchmarks drive flows of billions of dollars. Compiling an index is no longer passive. We write so much about the S&P 500 and the MSCI Emerging Markets because they really, really matter — not just for the passive money tied to them directly, but for the influence they exert over the many active managers who are benchmarked to them.

On this basis, it’s not clear we should much care about the Dow. Its use as a benchmark for active managers is minimal — as in I’ve never met an equity manager who used it as a target. There is an exchange-traded fund that tracks it, offered by State Street, which also offers the behemoth S&P 500 index ETF. The Dow ETF holds $34 billion. The S&P ETF has $525 billion. When the S&P decides to admit high-flying companies like Google or Facebook , it’s an event with real ramifications. Fiddling at the margins of the Dow doesn’t matter.

Since the Dow ETF was launched in 1998, incidentally, its market cap has fallen steadily further behind the S&P 500 — although thanks to the strength of the US stock market and the growing popularity of indexing, both have snowballed in remarkable fashion. This is how the two have grown since then, indexed to the launch of the Dow fund.

Indexes matter more than ever. They frame and lead the investment world. But the Dow doesn’t. And despite the journalistic assumption that mom and pop investors are still more interested in the Dow, that is contradicted by the evidence of where they actually allocate their dollars.

Limited Revelations from the Results

Over a span of slightly over seven years since it crossed the 20,000 mark in the first week of Donald Trump's presidency in January 2017, the Dow Jones Industrial Average (DJIA) has doubled. However, its performance has been overshadowed by its underrepresentation of major tech platforms, causing it to lag behind the S&P 500 by over 25 percentage points. Despite this, the DJIA has nearly mirrored the results of the equal-weighted S&P 500, where each constituent holds a weight of 0.2%.

Assessing the DJIA's performance against gold, a historical measure, reveals that it has remained essentially flat since reaching the 20,000 milestone when measured in gold rather than dollars. Particularly since the onset of the pandemic, it appears that liquidity and monetary expansion have been primary drivers of the DJIA's recent record highs.

Notably, the rate of the DJIA's ascent, averaging exactly 10.0% annually during its most recent doubling, is not exceptionally rapid. Previous doublings, such as the one from 10,000 in the spring of 2019, were hindered by events like the dot-com bubble burst and the global financial crisis, resulting in an average growth rate of 4.02% over 18 years. In contrast, the late 1990s witnessed a remarkable ascent, with the DJIA doubling in just over three years at a compounded rate exceeding 20% per annum.

While celebrated milestones in the DJIA's history have often coincided with significant market events, their impact remains unclear. Despite the attention garnered by these milestones, the rationale behind their importance is seldom explained by journalists and analysts. If there are unique insights or guidance to be gleaned from the DJIA that cannot be obtained elsewhere, it remains to be articulated.

Source: Moneycontrol