The Meaning of the Dow

The Meaning of the Dow

"The Dow has fallen again today, closing 200 points off." What does this common enough sentence mean to you? To some, it may be just financial mumbo-jumbo, but to a number of people it is an indication that their retirement may not be as relaxed as they had hoped, as many retirement plans in the USA are bound up in the performance of the markets, through 401K tax-deferred plans.

First things first, the Dow referred to above is more correctly known as the Dow Jones Industrial Average, and it is a widely accepted measure of the state of the US economy. Invented at the end of the19th century, it now combines the values of 30 industrial companies to give an overall indication of the financial state of the country. It is an average, but not all of the selected companies are equally represented in the overall figure. There are weightings applied to each to try and give a better overall picture. Although there is nothing magic about these 30 companies, the leaders at the Dow Jones endeavour to select the most representative in their particular field, and thus maintain the recognized standard.

There are other combined indicators, of course. The S&P 500 is one that you may have heard of, and that tracks 500 companies. The Russell 2000 goes even further, following the fortunes of, you guessed it, 2000 companies. In fact, the Dow is unusual in only selecting thirty to represent the whole market. Not that that is where they stop, of course. Any follower of the markets knows that Dow Jones have many more indices in many more markets and sectors - at last count, there were 130,000 indices being tracked by Dow Jones!

However, the DJIA is held to be the important one when it comes to gauging the health of the American nation. This position is carefully guarded, by periodic reviews of the companies that are included. This is demonstrated by the fact that the index is usually well correlated to indices with many more component stocks, such as the S&P 500.

On the other hand, some would argue that the DJIA is outdated, and not a good representation of the markets, because of this limited number of stocks. The other reason for questioning the accuracy of the Dow as a gauge of the economy is that the weightings applied are related to the prices, rather than the capitalization of the companies, which means that larger firms may not have as much impact as you would expect.

The components of the Dow Jones Industrial Average are not changed often, but two companies were substituted recently, in February 2008. When this happens, the editors are careful to adjust the weightings to keep the total consistent with the previous values. You won't find the editors taking in any transportation or utility companies, as these are covered in other major Dow Jones indices, but otherwise they have freedom to choose which stocks they wish. The emphasis on market sectors does shift, however, to reflect the current business world.

The Dow is maintained by the editors of The Wall Street Journal, which is published by Dow Jones & Company. Charles Dow was the first editor of The Wall Street Journal, which appeared in July 1889, although it was preceded for some years by similar financial bulletins. The index was started by Dow with just twelve stocks, in 1895. Only one of those original companies is still on the index - General Electric. The number of stocks increased to twenty in 1916, and has been thirty ever since 1928, for the last eighty years.

Mr Dow's editorials, which appeared in the last three years of his life, up to 1902, have also spawned the "Dow Theory", which many believe can be used to predict price movements. This theory tries to correlate the movement of the industrial index with the transportation index (the Dow Jones Transportation Average), arguing that the DJTA must confirm the direction of movement of the DJIA for it to have staying power. It's been noted that Charles Dow closely followed the interactions of the two indices, and there are devotees who still advocate considering the actions of the DJIA and the DJTA, to note when they are moving in agreement, as this will confirm the movement. As the saying goes, one "makes" and the other "takes", so both should gain in a healthy market, and if they do not move in unison, there may be a problem with the apparent direction. You can find more information on the Dow Theory and on stock analysis in general by studying the course which is available at www.insightsupport.com for free.