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February 25, 2009

Why the Dow Jones average is terrible

Today I present my biennial anti-Dow column. They never seem to make any difference. Today's starts out:

The poor Dow Jones industrial average. It's under attack again, and not just by fearful investors dumping shares and driving it toward 7,000.

"Some critics say the Dow is an inherently flawed gauge of overall market activity," The New York Times reported in 1986.

They're still saying it, only louder. Poorly designed, more than a century old, the Dow is less relevant than ever. For all the alarm it is causing, the diving Dow actually understates the fear in the economy and the stock market.

Here is the first Hancock anti-Dow column, from April 4, 1999:

DOW 10,000? Ignore those headlines.

"The Economy" is here to tell you that the Dow Jones industrial average has been propped up by shadowy East Coast power brokers who have a big stake in the bull market.No, not the Fed.

The Dow was "adjusted" March 17, 1997, by the people who invented it: Dow Jones & Co., publishers of the Wall Street Journal. A committee of green-eyeshade types juiced the lineup, blackballing four down-at-heel Dow members and picking ringers as replacements.

Out went Bethlehem Steel, Woolworth, Texaco and Westinghouse. In came Johnson & Johnson, Wal-Mart, Hewlett-Packard and Travelers. One eighth of the Dow membership changed that day, but you'd never know it from looking at those mountainous Dow graphs. The plot line rises unbroken, one pure Dow, as it was and ever shall be.

Without the switch, by my calculation, the Dow would have been near 9,000 last week. Not 10,000.

Bethlehem Steel is worth $8 a share these days -- same as two years ago. Woolworth, now called Venator, sells for $7, one third its 1997 value. Meanwhile, Johnson & Johnson is up by half. Wal-Mart has tripled. The new ingredients added some fizz.

It's no crime. Dow Jones has been fiddling with the blend of 30 firms since shortly after the index was created and included companies like U.S. Rubber and National Lead. The 1997 change was only the latest of many.

The Dow is supposed to reflect big business, the thinking goes, and these days big business is more about computers and financial products than oil wells and dime stores.

Here's the point: By discriminating against sunset companies and favoring growing ones, the Dow has a selection bias as big as Manhattan. The Dow is not the economy. It's not even the stock market. It's a slice of the stock market as seen by a few people in New York who "could run into somebody in the men's room" to start talking about the next Dow makeover, as index editor John Prestbo told Fortune magazine.

Science it ain't.

What's more, there is some conflict of interest. Don't make too much of this, but the ascent of Dow Jones the index clearly helps Dow Jones the company.

While the Dow is up more than 10 percent in the past year, Standard & Poor's index of 400 mid-size U.S. companies is flat, and S&P's 600 smaller-company index has plunged by a fifth.

"The Dow has been given this life of its own. The higher it goes, the better," said Donald J. Cunningham, a professor in the educational psychology department at Indiana University. "It is kind of like this religious symbol, in that we're bowing to it."

Cunningham is director of IU's Center for Applied Semiotics. Semiotics is the study of symbol, sign and metaphor; its most famous practitioner is novelist Umberto Eco. As any semiotician can tell you, the totems that lend meaning and direction to our days aren't necessarily the same as reality.

"You have to have stories you tell about the way things are," Cunningham said. "Whether or not they are true isn't really important."

Take the Dow. "The numbers mean nothing," Cunningham said. "You can re-sort the stocks. Ten thousand is as meaningless as 32 on the temperature scale. What does it mean? If you convert to Celsius, nothing. Well, somehow we have equated this Dow index with the health of our economy."

Cunningham isn't the first person to connect stocks with religion. "The Market as God" is the title of Harvey Cox's recent article in Atlantic Monthly.

French mathematician Blaise Pascal argued that rational people should believe in God because if you bet on God and he's real, the rewards are infinite. And if God is not real, there's no downside.

You can't say that about the Dow.

But salvation feels good meanwhile. Pay no attention to that man behind the curtain, er, men's room stall.

Posted by Jay Hancock at 11:30 AM | | Comments (3)
        

Comments

I just wanted to comment on the article and an observation that I made. Though I do not have nearly the experience and background of Jay Hancock it seems to me there is an obvious flaw in his point. If the DJIA is irrelevant, is he saying the S&P 500 is a better indicator of the economy? Is there a better indicator? Has he noticed that over the past 10 years the DJIA and the S&P 500 have changed almost "lock step" exactly? It would seem this is an argument that would say the DJIA is as accurate as the most accurate other index. If it weren't, then the charts would be wildly different. His stabs at Rupert Murdoch make me think this is a stab at the conservatives instead of a rational observation on the indexes. Your thoughts?

I agree it is propped up. But it is headed much lower than 7,000. With Wall Street
corruption and a shrinking GDP. A large
portion of the US population bankrupt
and without work. No money to play the stock market. It has only one way to go. The FED just slowed the Dow's rate to it's destination. The difference between a crash and a soft landing.

I'm not sure I would ask a school psychologist too much about investments!

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About Jay Hancock
Jay Hancock has been a financial columnist for The Baltimore Sun since 2001. He has also been The Baltimore Sun's diplomatic correspondent in Washington and its chief economics writer. Before moving to Baltimore in 1994 he worked for The Virginian-Pilot of Norfolk and The Daily Press of Newport News.

His columns appear Tuesdays and Sundays.
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