WTF is the DOW Index?

So this is for the !Stock Picking Discussion #Forum because as it turns out a lot of people who might want to invest don't know what those news-making indexes are or why they should or should not matter.

The attached article below is a link to a Google Spreadsheet document that calculates the Dow Jones Industrial Average live. You can click around in the cells to see how it's calculating to come up with the number talked about on the news. Their's lots to say about this one, so I'm going to thread comments below to explain more...

FAQ 1: Can I buy shares of the Dow Index?

Yes and No. I don't want to get too far into the weeds here, but through the magic of #MutualFunds (what Funds are will be a different post), and some of them being listed on the #Exchanges as #ExchangeTradedFunds, people can buy and sell "shares" of something closely resembling the DJIA.

If you were to buy a single share of the DJIA today (as of the time of this writing). it would cost you $3,996.67 to get 1 share of each of the 30 companies in the DJIA.

So why the hell is the DJIA on the news valued at 26,949.99? Well, when they first made up this index, everything was different. Some companies have a stock price grow pretty high, and to lower its price they "split the shares"; if the split is 2 for 1, people have twice as many shares but the price of each share is half of what it was before the split. The lower price makes it easier for most people to buy or sell its shares. However, the DJIA would be wrong to report that newly lowered price which just halved so they came up with a divisor trick that would correct the true value that the index would be at if it didn't split, and to also include the value of cash dividends when companies pay them (what dividends are will be a different post).

If you put in thought about that Dow Divisor, you can see how keeping it up would be a real mess. In my own opinion, the DJIA is no longer a reasonable index to measure the health of the markets and it should be done away with like turnips at holiday dinners; can't we all start having sweet-potato pie instead?

Another fun fact is that sometimes they kick companies out of the index and bring in new ones. Check out the Wikipedia page for details.

FAQ 2: What's an Index?

An Index, in a financial market, is a contrived method for trying to guess the conditions of the market as a whole or an identifiable subset of the market. I'll offer a real-life metaphor to compare indexes to.

Suppose I was going to host a party for you and you would have 30 guests at it. Certainly we care about the success of the endeavor, but what way can we tell if it was a success? They are your friends and maybe they won't tell you the truth if my services were bad because they don't want to hurt your feelings. In this metaphor, I am the market, foods and drinks are stocks, you are a stockbroker/financial advisor, and the guests are investors. We could come up with an empty plate index as a measure of the party's success. It could work, but what if my employees know that and just start eating the food to clear plates, or just dumping food into your heating air ducts to hide it? Maybe a smile index would do? That seems reasonable, but suppose most of the party conversation begins to discuss world hunger and poverty? Surely it's not my fault that they aren't smiling! You can see how hundreds of schemes could be made for trying to gauge the success or failure of the party. The real goal is to discover some general truth of the world so as to better plan for future decisions. It's by having an index that we can also begin to analyze smaller classifications of things. Imagine that we found an index and it showed the food was great at the party. Later when we looked we saw almost nobody tried the scones. That would be a strange anomaly. Were they bad? Were the guests uncultured about the joy of scones? Was the time of day the wrong one to serve scones? We do this sort of thing when judging an individual company being traded by comparing it's pricing fluctuations to an indexes value fluctuations. But picking the right index is important. This type of anomaly is just what triggers an investigation, not what concludes it.

In this thread, we are focused on the DJIA (an oversimplified average), but it isn't the favorite for savvy investors for many reasons, kind of like the smile index was a bad idea for the party. To know why its a bad index is to better know what an index is, so let's think about that now.

What if the party metaphor above wasnt just a social party, but instead was a fundraiser? Suddenly, the net worth of each guest becomes important because richer people can afford to donate more. Similarly, some companies in the stock market are bigger, so represent more of the total market. For a moment, let's think selfishly about what that could mean. A retirement fund might be invested more in bigger companies than it is in small companies. If a big company has a lowering price, we must care more about it than when a smaller company does the same. If you look closely at the way the DJIA works, it is treating each company as one share of 30 disregarding their size in the market. Microsoft carries 14.01% of the total market cap in the 30 and The Travelers Companies, Inc. only represents 0.51%. Despite this variation, they are both trading at about the same price per share. You should care 28 times more if the DJIA goes down 1% because of Microsoft than it does from Travelers!

Probably all indexes that arent the DJIA use the Market Capitalization to weight the average of the current prices paid for the companies in the index. The general idea of the index is to gauge the health of the market. For decades, the go-to index has been the S&P 500®. Depending on which markets you care about, from as small as the old AMEX to as big as the entire Earth, the USA has somewhere over 10,000 valid companies trading publicly on the NYSE, AMEX, NASDAQ, and OTC. So that S&P 500, as useful as it is, only looks at 5% of the stocks being traded. The Wilshire line of indexes encompass more of the total market, but sometimes the focused index is better.

For you personally as an investor, you will find specific indexes that have a tighter fit on the type of stocks you own or intend to own.

Earlier in the metaphor, I hinted at your guests possibly lying to you about how good things are going. I didn't do that flippantly. It's common that companies will have an erroneously bright outlook on their future profits (an important factor in stock prices), only to have it turn out to be wrong. You can imagine many ways low level to high-level managers can miss the mark when executives are asking for forecasts. Though we have many metrics that come from companies public reporting of internal books, we don't make an index out of those metrics. There's an important school of thought called The Efficient-Market Hypothesis, which I personally favor strongly over other price determination hypotheses, and it argues that thousands of pro's in trading are analyzing every actively traded stock at all times, so when something happens—good or bad—to a company, the price will immediately adjust to the true value. Because the price a company trades at is rarely a lie and is wildly easy to access, it becomes the ultimate thermometer used in indexes. Price isn't the only index though. Many new concepts are gaining favor; social good indexes, carbon footprint indexes, and so on. Price is still the most respectable indicator to use.

FAQ 3: Do Indexes measure the Economy?

Um, yes, but mostly no. They measure the economy in the same way that a big-appetite can measure the health of a person.

The #Economy of an entity, be it the entire Earth, a group of countries, single countries or even smaller entities like cities or rural towns, is like an #Environment of the same entity, but it focuses on how our decisions affect each other within the entity. In prehistoric times the economy was things like a freshwater stream, a berry bush, a fruit tree, some predator and prey animals, you & your family, and who gets to have what. We can assume they had a net positive economic system because we are here today in greater numbers.

Almost anybody who reads this can, in a moments thought, conclude that the price of a stock in an #index has very little to do with their personal experiences in the economy. If you try to imagine that every private business (not traded on an open market like #NYSE, #NASDAQ, or #OTC), from the next-door neighbor's side-hustle that is only a #business on their tax forms such as a Schedule C sheet or a number in the Other Income box on the main page of their 1040, to #companies as big as Cargill, it seems obvious that most of the Economy isn't part of the #stock #market. Clearly, private companies cannot possibly be measured by any index of any market. They are all certainly part of the economy. Some parts of the economy defy all aggregate measurement, like when the excess heat waste of buried pipes of a manufacturing plant makes the land above them ideal for a Northern farmer to build a winter tolerant tomato farm under glass. Some parts of the economy we can measure, but because of power in the wrong hands we don't, like the negative cost of pollution on all of society and the environment versus the cost of responsible handling of the same waste product, be it a smokestack of a coal-fired electric power plant or a pig-shit lake running off into a freshwater stream people get their drinking water from. The economy is so big and detailed, and an index is so focused and simple that it should be obvious that it does not measure the economy.

But it does measure something! Just like a big appetite for food can show that a baby is healthy, or a person in the hospital is recovering, an index can tell something about the economy. The indexes are aggregating price changes in the stock markets. #Price changes in the stock market are in general changing because at least two people have simultaneously thought, that's too low & that's too high, and had the ability to transact in that companies stock. We can have wishful thoughts about that price meaning the worth of that company (Market Capitalization), but it's not too much so; mostly its desire-driven based pricing on the perception of future earnings potential. When a company first issues the stock in a way that the "public" can buy shares (to become Outstanding Shares), the buyers are handing the company cash to do projects for profit in exchange for some ownership claim to the company. Most of the public trading has nothing to do with the day to day operations of the company. If they want to launch another big project and want to issue more stock to fund it (selling Treasury Stock), they would care greatly what the current price of their stock is selling at. It might seem like everything I'm writing proves indexes are not measuring the economy, but that connection between sentiment and price is an indicator. Since goods and/or services a company offers are where it's profit & potential profit comes from, and desirable products and services are a fundamental component of every economy, an index going up hints at a bright future for the economy, in as much as the part of the economy that is publicly traded in the stock market. Though that segregation of public/private exists, both the company types have equal access to the whole economies customers, so there is a connection to the economy from an index albeit a sentimental one where people back their opinions with their own money.

Please note that price changes don't directly mean the underlying company is worth more or worth less, it just means that the last buyer-seller combination has agreed to trade money for a tiny slice of ownership at that price per share. For example, the day I was writing this, Nike had great earnings news come out the day before and there was a flood of shares changing hands; over 1% of the companies outstanding shares changed ownership. (lolz, over 1%!!!) If a company like Nike has a really monstrous day they might have up to 4% of the ownership change hands. Some of that is automatic trading in weight managed funds, and some of that is day trading speculators who will buy and sell in the same day or week. The volume of the shares being traded is fairly important but the news does not have a way to adjust the fuzzy logic level of certainty of the index according to volume. You need to keep that in mind when evaluating what an index is saying compared to other metrics. Seeing a cloud in the sky doesn't mean you need to carry an umbrella.
#BTW today's #Marketplace podcast is related...
The stock market is not the economy … so what is it?

Embedded player local to this post

Linked player via

After much procrastination, here is the S&P500 version of that linked DJIA Google Spreadsheet attached to the initial post:
The main difference is the DJIA is a badly planned average of prices and this is a weighted average where the size of the company relative to the other companies sizes will change its importance. That makes sense because if a $4-million company changed its price by 5% and a $3-billion company changed its price by 5% we wouldn't think they are equal with respect to the health of the overall stock market.

This website uses cookies to recognize revisiting and logged in users. You accept the usage of these cookies by continue browsing this website.