There is nothing better than finishing a week with the financial market hitting all time highs! Especially following one of the most, if not the most, contentious Presidential debates in history. It seems as if all the walls of uncertainty have crumbled and illuminated the path to the illusive leprechaun’s pot of gold! In truth, though, investors woke to a surprising development where word of a COVID vaccine study showed promising signs. It was if it was Christmas morning with many alike shouting “The DOW, bro” in reference to the Dow Jones Industrial Average (stock market index) 5.3% surge early Monday morning from the vaccine present. But, in effort to not sound like the Grinch, that Monday morning’s surge was short lived and began fading with the Dow closing the day 2.9% higher. Nonetheless, the Dow’s rally caught the eyes of many thus spurring the look at “The DOW, bro” chatter clatter. And although the daily performance was impressive, I found myself confounded on why a number of investors both professional and retail quote the Dow as if it is the ordained benchmark of stock performance. Unfortunately, that is furthest from the truth.
Today over coffee, I am going to provide a background on stock market indices and the stark differences on the Dow Jones Industrial Average compared to the S&P 500. While all stock indexes aim to show stock performance, they are not similar in construction and representation. So grab your cup of coffee and enjoy!
Bullet points for my high-speed espresso drinkers:
All stock indexes are similar in the sense that they aim to show the performance of stock but highly differ on how they function
The DJIA tracks only 25% of the total value of U.S. stocks publicly traded
The S&P 500 tracks 80% of the total value of U.S. stocks publicly traded
The DJIA doesn’t is a poor representation of the stock market
One of the most confusing terms, and one I am guilty of perpetuating, is the use of “financial markets” in a sentence. The term is used to interchangeably describe the performance of financial assets such as the bond market, commodity market, currency market, derivative market, stock market, etc. And to make it more confusing, when the term “stock market” is used, one may be unclear as to which stock market is being referenced. In fact, according to Investopedia, there are approximately 5,000 U.S. stock indexes. Thankfully we will not dissect each one since its Saturday, but it is important to know that the commonly referenced stock indexes in the U.S. are the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite.
Now before I get on my soapbox on why following and quoting the DOW can be misleading and a fool’s game, I want to take a step back and explain what a stock index aims to achieve. Financial market participants (anyone watching or investing assets) rely on the stock index as a benchmark and/or proxy to gauge the overall performance of the stock market. This is accomplished by constructing stock indexes with a specified criterion of stocks. For instance, the Russell 2000 aims to provide a stock index for the small publicly traded companies whereas the S&P 500 tracks the largest 500 publicly traded companies. Furthermore, each stock index, based on the stock criterion, sets defined parameters and characteristics on how the weight each publicly traded stock within the index. Below is sample of the different types of weighting parameters that stock indexes use. You will see the glaring realities between each one.
Price Weighting: This stock index method weights companies proportional to the company’s price per share (stock). What this means is that each price of stock in the index is added together and divided by the total number of companies in the index. If a stock price is higher for a company, they will receive a higher weight than one with a lower price. It is important to remember though, high stock prices DO NOT necessarily mean high company value. The Dow Jones Industrial Average is a price weighted index
Market-Capitalization Weighting: The size of publicly traded company is known as its Market Capitalization. Therefore, some indexes weight each stock based on the size of their company rather than their share price alone. The S&P 500 is a market-capitalization weighted index.
Equal-weighting: Each stock in the index is equal weighted therefore reducing any size biases. What this means is that each stock is given an equal chance to contribute to the overall performance of the index rather than being driven by a handful of mega-large companies. An example would be AAPL and AMZN. This weighting scheme is one of our favorites and highly used in our analysis. The S&P 500 also has an equal-weighted index.
Now that we have established a baseline understanding of how stock indexes are constructed, we will be able to see why using the Dow Jones Industrial Average (DJIA) is a misleading benchmark when it comes to the performance of the overall stock market. To be fair, the DJIA is one of the oldest and most well-known stock indexes in the world. It has provided rich history for many companies that have been publicly traded has given valuable insight to many market participants. The reason people still quote the DJIA is because it represents the 30 largest companies traded. Now this seems impressive, especially when the DJIA value moves significantly like it did on Monday but it only represents approximately 25% of the value for U.S. publicly traded companies. Furthermore, the dramatic price day moves are highly misleading based on their stock weighting approach: price weighting.
Investopedia provides the following statement: “The basic problem is that a $1 change in the price of a $120 stock in the index will have a greater effect on the DJIA than a $1 change in the price of a $20 stock, although the higher-priced stock may have change by only 0.8%, and the other by 5%.”. This is precisely what happened Monday with the announcement of Boeing being able to potentially sell 737 Max planes.
Based on the DJIA construction, we prefer the S&P 500 as more accurate benchmark to the overall performance of the stock market is it represents approximately 80% of the value for U.S. publicly traded companies. Another unique future of the S&P 500 is that their criteria stems far behind mere stock price size as they only include stocks that fit liquidity profiles, stock availability (enough stock in the market to buy), sector classification, and trading history. Lastly, the ability to view the stocks either on a market-capitalization weighting or equal-weighting provides a clearer picture to the relative performance of stocks rather than price-weighting.
While it seems conventional to quote the stock market in DJIA daily points, I implore market participants to benchmark their investments, or view the stock market, through the lens of a market-capitalization weighted index such as the S&P 500 as it will provide a more accurate gauge on price performance.
I hope this lesson on index construction was helpful!
Have a relaxing and good weekend.