The silly, underperforming Dow

By Felix Salmon
January 7, 2011
Eddy Elfenbein notes that the Dow has significantly underperformed the market of late. Here's how it compares to the S&P 500 over the past 180 days: up 16.6%, which is great, but not nearly as great as the S&P's 19.9% gain.

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Eddy Elfenbein notes that the Dow has significantly underperformed the market of late. Here’s how it compares to the S&P 500 over the past 180 days: up 16.6%, which is great, but not nearly as great as the S&P’s 19.9% gain.

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Is this a bearish sign of speculative activity? Perhaps; Eddy’s theory is that “the Dow hasn’t captured the strength in cyclical stocks.” But the big picture, of course, is that the Dow is a ridiculous way of measuring the stock market, and that it’s certain to diverge from the S&P 500 on an irregular basis. The real surprise, frankly, is not that it diverges as much as this now and then, but rather that it hews so closely to the broader stock market most of the time.

One thing worth noting here is that two of the top five companies in the US, by market capitalization, are essentially disqualified from being part of the Dow: Apple is over $300 a share and Google is over $600 per share, which makes it impossible for either of them to enter a price-weighted index. Google has 1.38 times the weighting of Bank of America in the S&P 500; if it entered the Dow, it would have more than 43 times BofA’s weighting.

I do wonder what it is about the Dow which keeps it alive in the popular imagination and the financial media. I think it might have something to do with having an index level in the thousands: it’s like video-game scores, which always add a few zeroes just to feel more impressive. The S&P 500 should probably have been set to 500 rather than 44 at inception in 1957: then there would be no need for the silly Dow at all.

10 comments

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I think that the Dow following the S&P 500 closely is an illustration of how much of an underlying “market component” to individual stock returns there is. I don’t believe the CAPM is literally correct, but that doesn’t change the fact that a significant proportion of idiosyncratic returns are explained by aggregate market returns.

Posted by Beer_numbers | Report as abusive

Felix, the Dow and S&P don’t merely represent different stocks, they have somewhat different characteristics. When they diverge, it has nothing to do with whether the index is measured in the hundreds or in the tens of thousands. It is an indication of shifting market sentiment. (While I don’t pay that much attention to the DJIA, it is strongly correlated with certain baskets of stocks that I *do* track for this purpose.)

Your supposed “big picture” is actually missing the big picture. The market is not a monolith, it has several different sectors with different characteristics that ebb and flow somewhat independently of each other. Focusing on a single measure is generally uninformative.

Posted by TFF | Report as abusive

I hope that at some point, you will address today’s WSJ report that Facebook is signaling its intention to go public as early as next year, given that you’ve devoted several recent blog posts to the opposite argument: i.e. that Zuckerberg and Co. in fact have every reason and intention to remain private. Maybe you read the latest signals differently. But absent an alternate interpretation, they seem to contradict much of what you’ve been saying recently. Or am I mistaken?

Posted by oxman | Report as abusive

Good column, Felix.

The Dow Jones index is a piece of historical ballast that, like the calendar and the QWERTY keyboard, should be either updated (no pun intended) or scrapped, but that’ll never happen. It probably has more to do with human perceptions and resistance to change than anything rational. As I recall, the French revolutionary leaders attempted to bring in a ‘modern’, ‘scientific’ calendar – Thermidor was one of the month names, I think – and it flopped.

Moral: Never underestimate the power of inertia in human affairs, be it calendars, keyboards or stock indices.

Posted by Gotthardbahn | Report as abusive

“But the big picture, of course, is that the Dow is a ridiculous way of measuring the stock market”

YES Felix! This needs to be shouted loud and proud by people with big voices. As for why it persists? Status quo. that’s it.

TFF – I think Felix’s point is that the Dow is a portfolio that is contructed in a way that NO ONE with a brain would or should ever construct a portfolio. Thus, it’s asinine to look at and talk about so much.

For the uninitiated, if you own a Dow basket, you own the same number of shares of each stock – that’s what “price weighted” means, and it’s moronic. We all know that the price per share of a stock is a random number – it can be adjusted at will via splits and reverse splits – yet it’s the driving force behind the Dow. Said differently, if a $100 Dow stock goes up 5%, it impacts the index 5 times as much as if a $20 Dow stock goes up 5%… that’s absurd.

Posted by KidDynamite | Report as abusive

KD, of course it is absurd! But consider the big picture — despite being completely absurd, it serves just as well as the S&P500 for most purposes, and (unlike the S&P500) reinvests dividends so you don’t need to calculate that separately.

Posted by TFF | Report as abusive

KD, of course it is absurd! But consider the big picture — despite being completely absurd, it serves just as well as the S&P500 for most purposes, and (unlike the S&P500) reinvests dividends so you don’t need to calculate that separately.

Posted by TFF | Report as abusive

I completely agree with you, Felix. Thanks for your clarification of the issue.

Posted by kahmet | Report as abusive

You miss the licensing fees that DJ earn.

Posted by signdude | Report as abusive

The reason is that “Dow Jones Industrial Average” sounds much more important than “S&P 500″, and probably includes all stocks, rather than a mere 500.

Posted by DrFuManchu | Report as abusive