Measuring the Market
Many people measure the market's rise and fall using the all-popular Dow Jones Industrial Average (DJIA), which includes a mere 30 companies. Most people, including experts, watch the DJIA because they believe it sets a trend for the market. Be aware that the index does not measure the mood, but defines it.
Some background: The averages were based on the writings of Charles Dow, the founder (along with Edward C. Jones) of The Wall Street Journal. The paper originally began publication on July 3, 1882, as the Customer's Afternoon Letter, and was renamed on July 8, 1889, with Dow as its first editor. The original Dow Jones Average of 12 stocks appeared for the first time in the first edition.(The original 12 stocks were: American Cotton Oil; American Sugar; American Tobacco; Chicago Gas; Distilling & Cattle Feeding; General Electric; Leclede Gas; National Lead; North American; Tennessee Coal & Iron; U.S. Leather preferred; and U.S. Rubber. Of these, only General Electric remains on the averages today. For more information and statistics about the DJIA, check the Web site averages.dowjones.com.)
After Dow's death, his successor as editor, Samuel Nelson, published a book, The ABCs of Stock Speculation, in which the well-known Dow Theory was introduced. The theory is a market-wide version of support and resistance levels. This form of technical analysis is widely followed, even by those who consider themselves faithful only to fundamental analysis. The theory is based on overall movement patterns of stocks, without any regard for economic factors. The Dow Theory is not a gimmick. It is based on the belief that primary movements in the indexes establish very real trends. That does not change the tact that the DJIA is a technical indicator.
In 1916 the list was increased to 20 companies, and on October 1, 1928, it was expanded again to today's level of 30 industrial companies' stocks.( As of the beginning of 1998, the 30 stocks included in the DJIA are: AT&T; AlliedSignal; Aluminum Company of America; American Express; Boeing; Caterpillar; Chevron; Coca-Cola; DuPont; Eastman Kodak; Exxon; General Electric; General Motors; Goodyear Tire & Rubber; Hewlett-Packard; IBM; International Paper; Johnson & Johnson; J.P. Morgan; McDonald's; Merck; 3M; Philip Morris; Proctor & Gamble; Sears; Travelers Group; Union Carbide; United Technologies; Wal-Mart; and Walt Disney.)
The theories on which market trend analysis was originally based may be out of date today, in many respects. The world has changed. Transportation and utility companies may not have the kind of market influence in the twenty-first century that they held when Dow first published his ideas. Today there may be greater influence from technology, automation, communications, and other industries.
The "industrial" averages originally were largely financial. Today, the stocks in that average include a more diverse selection of companies, which is appropriate as the world changes and especially as the United States' economy moves away from a manufacturing emphasis and "industry" has become dominant overseas.
The DJIA is the most widely used indicator, believed to show a "central tendency" or trend in the companies represented within the index. But there are several problems with this approach. First, the criteria on which a stock is selected to be included in the DJIA are not published. Second, the index is not weighted to equalize share prices for different companies. As a consequence, companies with higher-priced stock have a correspondingly greater influence on the averages. So when you hear that the market "went up" today, that should not be taken as a broad indicator of market health. It is a summary of what happened in only 30 companies; and those among the 30 with higher capitalization exert greater influence on the level of the index.
From time to time, some stocks are removed from the DJIA, to be replaced with other stocks. Why? What changes led to the removal of one or more companies, and to their replacement with others? How were these more representative, more suitable, or more desirable from the point of view of the market? It is possible that much of the rise in the stock market during so-called bull market periods may be attributed to the selection criteria by Dow Jones & Company, rather than from any specific economic or market-based changes or trends.
A more accurate measure of the market in terms of price movement may be the Dow Jones Composite Index. It covers all stocks included in the industrial, transportation, and utility averages and reports them together. This index, while broader and thus more representative of market movement, has two primary problems. First, it has not caught the imagination of market watchers like the industrial averages have. Second, it represents only 65 stocks, a small portion of the whole market.
The problem with any index that includes only a handful of the thousands of listed companies is that someone has to decide which companies
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to include. Over the years, the stocks included in the three Dow Jones market indexes have changed. In theory, these changes reflect real changes in the corporate world. But how can we be certain that the makeup of highly selective indexes truly reflect market conditions?
We should be using the broadest possible indexes, if, in fact, we even think that overall market trends are important. The study of indexes may be useful in terms of actual timing of decisions to buy, hold, or sell, but a long-term investment strategy should not depend on today's market trend.
For the purpose of studying broader market trends, a study of the overall market makes more sense, even though it may be less interesting to the financial press. Standard and Poor's (S&P) 500 Composite Index includes 500 companies, compared to the Dow Jones Composite Index's 65. Though the S&P 500 still represents only a portion of the market, it is an improvement over the DJIA for three reasons. First, the S&P 500 is weighted, whereas the DJIA is not. That means that the relative value per share is identical for every company listed, regardless of the value of stock or dollar value of capitalization.
Second, 500 stocks represent a broader picture of "the market," and more accurately. The 500 stocks include 400 industrial companies, 40 utilities, 40 financial companies, and 20 transportation stocks.
Third, the S&P 500 is a true index rather than an average. The starting point, which is the market value of companies from 1941 to 1943, is averaged and then assigned a base value. So a change from the base value is a reflection of market changes, unlike the DJIA, which reports on the current average of stock prices with no equal base.
An even broader representation of the market is found in the New York Stock Exchange (NYSE) Composite Index. This is an average of prices for all stocks listed on the NYSE. The National Association of Securities Dealers Automated Quotations (Nasdaq) indexes, which began tracking on February 5, 1971, reflect price movement of the thousands of stocks traded not on the NYSE, but on the over the counter (OTC) market. The value of stocks is weighted so that, like the S&P 500, the Nasdaq indexes more fairly represent market trends than the DJIA. These far broader measurements include only United States-listed securities. Many trends in our domestic market are reflections of events overseas. So even a broader U.S. index may not truly reflect short-term trends in this country.
These methods of measuring the current mood of the market have become the obsession of Wall Street. Most of the analysis work found in financial publications arises from opinion and application of technical analysis based on a study of averages—in other words, short-term trends. These have no effect on long-term financial profit or loss.
Another interesting observation concerning index obsession is this: The more rational the index, the less interesting it is to the market watchers. This is a consistent pattern. The famous DJIA includes only 30 companies and yet, to many, it is the market. The more representative composite indexes, which attempt to capture all company stock trends, are largely ignored and often go unreported.
With computerization, you might expect fundamental information to improve in quality and availability. This is true. However, the primary change with automation has been an expansion of technical analysis. Today, the study of indexes has expanded and become highly specialized. Industry groups are studied regularly, not to mention foreign market trends, and technical trends in commodities, options, bonds, and other nonstock investments.
The computer has served to make the technician more efficient at producing opinion; it has not necessarily improved on the quality of that opinion. Graphic capability has made it easy to produce charts quickly and for a wide and diverse number of stocks, industry groups, and indexes. This never improves the quality of information; it only makes quantifying easier. So even with more reliable scaling, faster output, and greatly improved turnaround time, questionable information remains questionable.
