Financial Fundamentals: No Longer Industrial, Long Since Irrelevant

The ‘new’ DJIA: Now even more misleading

By Thomas K. Brueckner, Strategic Asset Conservation

As Americans have watched the stock market advance this year, despite a myriad of obstacles that would have derailed even a courageous investor five years ago, many have expressed amazement at the apparent return of “irrational exuberance,” Alan Greenspan’s now-infamous phrase describing his basis for the technology sector’s record growth during the late 1990s. After all, the DOW has rallied in spite of bad news again and again, even in the face of rising interest rates, political stalemate, political scandals, low volume, a slowing economy and now the potential outbreak of a multi-nation war in the Middle East.

Most recently, the committee that oversees the Dow Jones Industrial Average Index (DJIA) has changed its makeup in a not-so-subtle fashion. It has evicted Bank of America, Alcoa and Hewlett Packard, while welcoming Visa, Nike and Goldman Sachs as their replacements. To understand such a significant one-time reshuffling (three of just 30 companies is 10 percent)—and the self-serving rationale behind it—one need first understand the nature of the Dow’s “weighted average,” and how its calculus can misrepresent the health of or advances in the greater market.

First of all, the DJIA is hardly “industrial” any longer. Robert Stambaugh, a Wharton professor of finance, says, “They have tilted the index more toward financials. It’s called the Dow Jones Industrial index, but if you look at what they’ve done, two of the companies they’ve tossed out, HP and Alcoa, actually make things and sell them. They replaced those with Goldman, Visa and Nike. Goldman and Visa are financial services firms and Nike makes stuff and sells it. This reflects that financial services firms have a bigger presence in our U.S. economy.”

Really? Then why are there no banks in the index, especially given that there are plenty whose share prices are higher than Goldman’s and Visa’s?

Wikipedia agrees, saying, “The Industrial portion of the name is largely historical, as many of the modern 30 components have little or nothing to do with traditional heavy industry. The average is price-weighted, and to compensate for the effects of stock splits and other adjustments, it is currently a scaled average. The value of the Dow is not the actual average of the prices of its component stocks, but rather the sum of the component prices divided by a divisor, which changes whenever one of the component stocks has a stock split or stock dividend, so as to generate a consistent value for the index. Since the divisor is currently less than one, the value of the index is larger than the sum of the component prices.” (The emphasis is mine.)

Did you get all that? Another popular shareholder advocacy website puts it more succinctly. The Motley Fool says, “Because it is restricted to U.S.-based companies—and just 30 companies at that—the DJIA is not very diverse … It may not accurately reflect the performance of large swaths of the U.S. or global marketplace. Because it is price-weighted, it does not track the performance of the companies in a way that reflects a rational investor’s gains. To equal the Dow’s performance, an investor would have to buy the same number of shares of each company; such a strategy would force the investor to invest more money in companies with higher share prices, not a terribly rational way to invest.”

So there you have it. The “index of record,” the one that our media reports more than the others and a name synonymous with “the market” overall, is actually misrepresentative of not only the market, but the makeup of our national economy as a whole. At a time when many investors distrust government over its release of employment and economic growth data (remember that Q1 GDP was originally released at 2.5 percent only to be revised to 1.1 percent five months later—an exaggeration of 127 percent), what investors desperately need from Wall Street is a restoration of that trust.

Instead, the committee’s insiders have just taken an already out-dated, nonindustrial, and misrepresentative national benchmark, and made it even more biased in favor of those same insiders, at the expense of—you guessed it—the ignorance of the average investor. At a time when polls show that Americans (61.2 percent) overwhelmingly believe our nation is on the wrong track, it’s just more confirmation that their instincts may be correct. n

Thomas K. Brueckner, CLTC, is president/CEO of Strategic Asset Conservation in the Scottsdale Airpark, a conservative wealth management firm with clients in 18 states and six countries. He is a 2011 Advisor of the Year national finalist, a radio talk show host, and a mentor to other advisors nationally. He may be reached for comment at go2knight.com.