Inside the Dow

December 20, 1999

How well do you understand the world's best-known stock index?

Inside the Dow

How well do you understand the world's best-known stockindex?

By Dennis Murray, Senior Editor

It's nearly impossible to go through a day without seeing or hearingsomething about the Dow Jones Industrial Average, the oldest and most prominentmeasure of the US stock market. Since its introduction more than a centuryago, the Dow has done an excellent job of indicating which way the overallstock market is moving, even when compared with indexes composed of manymore stocks, such as the Standard & Poor's 500 Stock Index and the Russell2000 Index. From a historical perspective, the Dow, unlike any other index,paints a portrait of business in the US, from an economy fueled by smokestackindustries to one increasingly dominated by service and technology companies.

For these reasons, news of the Dow is commonplace in print and electronicmedia worldwide. Its daily "close" appears in major newspapersand on many Web sites, as do charts depicting how much the Dow has changedover various time periods.

Despite this near-constant exposure to the Dow, how much do you reallyknow about it? Can you name more than a handful of the 30 stocks that makeit up, and explain why the index includes these companies and not others?Do you know how the index is computed, let alone why it exists? This articlewill unravel some of the mysteries of the Dow. Consider the following:

When the Dow was introduced, most investors avoided stocks. Equitieswere considered extremely speculative in 1896, the year Charles H. Dow unveiledhis industrial stock average. Corporate raiders and Wall Street conniversdid their best to manage stock prices, which often moved on rumors and gossip—farmore than they do now. Not even Wall Street professionals had a real senseof whether the overall stock market was advancing, declining, or spinningits wheels. As a result, investors gravitated toward bonds, for their stabilityand predictability.

Enter Dow, with pencil and paper, to tally the prices of a dozen stocksand divide them by 12 to get an average. Grade-school math, to be sure,but his "formula" soon found acceptance. After being publishedirregularly for several months, the Dow Jones Industrial Average appeareddaily in The Wall Street Journal beginning on Oct. 7, 1896. It has beenpublished in each edition ever since.

Today's DJIA isn't really an average. When the Dow expanded to30 stocks in 1928, a divisor was introduced. This replaced the old methodof simply dividing the total stock prices by the number of stocks. Now,to calculate the Dow at the day's end, you'd total the closing prices ofits 30 components, then apply the divisor. For example, if the stocks' pricestotaled 2,071 and the divisor was 0.2, the Dow would be 10,355.

The divisor's purpose is to avoid distortions when stocks in the indexsplit or one company is substituted for another. Say Microsoft, which tradedat 92 recently, announced a 2-for-1 split. To compensate for the new stockprice of 46 and keep the average from dropping, the divisor would have tobe lowered. Likewise, when the DJIA added four companies and deleted fourothers on Nov. 1, the divisor was increased from 0.19740463 to 0.20435952,because the share prices of the new companies were higher than those ofthe departed ones. If the divisor hadn't been adjusted, the change in Dowcomponents would have caused the index to immediately—and artificially—risesome 375 points.

For every dollar that a Dow stock rises or falls, the index shifts byroughly five points. However, a high-priced stock is more likely to moveby a dollar or more than a cheaper stock.

The Dow is a price-weighted index. Because the DJIA is weightedaccording to the share prices of its 30 components, a 5 percent shift inAmerican Express, which traded at 152 recently, would have more than fivetimes the effect on the Dow as a 5 percent change in the price of Walt Disney,which sold on the same day for 28.

Even though American Express and Disney are roughly the same size interms of revenues, the higher share price of American Express gives it aweighting equal to 6.8 percent of the Dow, vs 1.2 percent for Disney. That'swhy critics say that price weighting makes the Dow a crude index.

Be that as it may, the Dow remains, as it has for more than a century,an excellent barometer of the overall economy. The Dow 30 represent morethan one-fifth of the $12 trillion-plus market value of all US stocks, andabout one-fourth of the value of the stocks listed on the New York StockExchange. So it should be no surprise that a number of investment vehiclestrack the Dow.

Newspaper editors are the keepers of the Dow. Although they consultregularly with industry leaders and financial experts, two editors fromThe Wall Street Journal—Managing Editor Paul E. Steiger, and John A. Prestbo,editor of Dow Jones Indexes—choose which companies to add to or drop fromthe Dow. Historically, changes have been made infrequently—about 10 companiesevery 25 years. However, eight changes have been made since March 1997,in an attempt to make the Dow more representative of the "new"economy, one that places greater emphasis on technology and service companies.

The last major shuffle came in November, when The Home Depot, Intel,Microsoft, and SBC Communications replaced Chevron; Goodyear Tire &Rubber; Sears, Roebuck; and Union Carbide. (For a listing of current Dowstocks, see page 76.) The four additions have increased an average of 3,800percent over the past 10 years, compared with 200 percent for the stocksthat were replaced, according to Wright Investors' Service of Bridgeport,CT.

Not surprisingly, the Journal's editors follow guidelines for selectingDow members. Although their definition of "industrial" is prettyloose, Prestbo and Steiger won't consider transportation and utility companies,for which Dow Jones has separate indexes. We'll spare you the minutiae ofthe remaining criteria, but basically the company must be worth billions,show few losses, and have broad ownership. It also must have a long trackrecord of good performance during up and down markets. Dividends used tobe crucial, but today they're less important, because companies plow moreof this money into research and development or use it to buy back stockinstead of paying it directly to shareholders.

Even after examining the recent changes to the index, critics of theselection process say the DJIA gives heavy industry too much weight, andburgeoning service and technology companies too little. The Journal's sisterpublication, Barron's, has suggested that America Online should beadded at some point, to better reflect the Internet's expanding influence.Barron's has also called for more representation from the pharmaceuticalsector, suggesting Pfizer and Bristol-Myers Squibb as good candidates. Inresponse, the Journal's editors have argued that the relative stabilityof the Dow's composition builds investors' trust in it. They've also citedreturns in line with other major market indexes.

Jettisoned Dow stocks can return to the index later. Of the 12original Dow stocks, only General Electric remains. However, GE left theindex in 1898 and was restored a year later. It was removed again in 1901,then reinstated in 1907, replacing Tennessee Coal & Iron.

IBM, too, has been selected more than once. It joined the DJIA in 1932,four years after the index expanded to 30 stocks. In 1939, it was pushedout in favor of AT&T. It didn't return to the Dow until 40 years later.A few other notables—Coca-Cola, DuPont, and General Motors—also were droppedfrom the roster, only to be reinstated.

Not one of the Dow's best years came during the 1990s. While it'sno shock that the Dow didn't experience one of its 10 worst years duringthe 1990s, it is surprising that, unless stocks take a big jump inthe next week or so, the index won't have had any of its 10 best years duringthis decade, despite the phenomenal run we've experienced.

The Dow's best year was 1915, when it gained 81.7 percent, to close at99.2. Its second-best annual increase, 66.7 percent, came in 1933, as theUS began to emerge from the Depression. To get a sense of how bad thingsreally were back then, you only have to look at the close at the end of1933—99.9, which was barely better than the figure from 18 years earlier.

All stocks trade on the New York Stock Exchange, except Intel and Microsoft,which trade on Nasdaq. 1Prices are through Nov. 1, l999. 2Numbers may nottotal 100 percent, due to rounding. 3Left the Dow in 1928; rejoined in 1939.4Left in 1935; rejoined in 1987. 5Left in 1925; rejoined in 1935. 6Leftin 1898; rejoined in 1899. Left again in 1901; rejoined in 1907. 7Left in1916; rejoined in 1925. 8Left in 1939; rejoined in 1979. 9Also in brieflyduring 1901. Source: Dow Jones

How soon to 16,000?

In its early years, the Dow took nearly three decades to climb 250 points.Now it's not unusual for it to gain that much ground in a single day. Hereare some of the index's milestones.



Dennis Murray. Inside the Dow.

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