The Dow Is Not Normal: Here Is Why

February 18, 2009 by Vagabond Investors

For those of you that like the stock market (as I do) I will ll give you a nut to crack. Many of you already know this, but those of you that are just starting out your investing career will find this interesting.

Many of you consider investing in Dow Jones. The market says that the Dow did this and The Dow did that. It is as if The Dow was a synonym for the overall stock market. If you think that that is a fairly accurate statement, hang on.

Why is it that The Dow is outperforming on the downside?
What is driving the index?

I will quote Mr. Bianco, CEO of Bianco Research LLC. In his excellent blog post entitled The Dow Is Distorted he made the following points.

The Dow Jones Industrial Average (DJIA) is a price weighted index. The divisor for the DJIA is 7.964782. That means that every $1 a DJIA stock loses, the index loses 7.96 points, regardless of the company’s market capitalization.

Dow Jones, the keeper of the DJIA, has an unwritten rule that any DJIA stock that gets below $10 gets tossed out. As of last night’s close (January 20), The DJIA had the following stocks less than $10.

Citi (C) = $2.80
GM (GM) = $3.50
B of A (BAC) = $5.10
Alcoa (AA) = $8.35

If all four of these stocks went to zero on today’s open, the DJIA would lose only 157.3 points. The financials in the DJIA are

Citi (C) = $2.80
B of A (BAC) = $5.10
Amex (AXP) = 15.60
JP Morgan (JPM) = $18.09

If every financial stock in the DJIA went to zero on today’s open, it would only lose 331.25 points, less than it lost yesterday (332.13 points).

If you want to add GE into the financial sector, a debatable proposition, then:

GE (GE) = $12.93

If the four financial stocks above and GE opened at zero today, the DJIA would only lose 434.24 points.

The reason the DJIA is outperforming on the downside is the index committee is not doing its job [emphasis added] and replacing sub-$10 stocks and the financials are so beaten up that they cannot push the index much lower.

So what is driving the index? [emphasis added] The highest priced stocks:

IBM (IBM) = $81.98
Exxon (XOM) = $76.29
Chevron (CHV) = $68.31
P&G (PG) = $57.34
McDonalds (MCD) = $57.07
J&J (JNJ) = $56.75
3M (MMM) = $53.92
Wal-Mart (WMT) = $50.56

For instance if all the sub-$10 stocks listed above, all the financials listed above and GE opened at zero, the DJIA loses 528.63 points. To repeat if C, BAC, GM, AA, JPM, AXP and GE all open at zero, the DJIA loses 528.63 points.

If IBM opens at zero, it loses 652.95 points. So, the DJIA says that IBM has more influence on the index than all the financials, autos, GE and Alcoa combined.

The DJIA is not normal as the Index committee is not doing their job during this crisis, possibly because of the political fallout of kicking out a Citi or GM [emphasis added]. As a result, this index is now severely distorted as it has a tiny weighting in financials and autos.

Now that is something for you to think about. We have talked extensively about the impact of politics on the market as well as the bailout plan with its shortcomings. The stock market, if let alone, is one of the freest markets there are. However, everything is subject to manipulation by central bankers, politicians and the like who are easily mistaken as honest people.

I will thank Mr. Bianco for his excellent comment and give a direct URL to his article if any of you should be interested: http://www.ritholtz.com/blog/2009/01/bianco-the-dow-is-distorted/

See you guys!
Jaakko

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