Demise of the Dow

America boasts the most developed capital markets on the planet — highly sophisticated and ruthlessly efficient. So it was quite a sight on March 29, 1999, when the cutthroat traders on the floor of the New York Stock Exchange suddenly started to act like giddy schoolgirls. The Dow Jones Industrial Average, the most widely quoted benchmark of the U.S. stock market, had just closed above 10,000 points for the first time, after weeks of frenzied anticipation. With the barrier finally breached, then-New York mayor Rudolph Giuliani, along with representatives from the NYSE and Dow Jones, showered 10,000 baseball caps on the excited kids below — all in celebration of the most out-dated, arbitrary financial yardstick in capitalism.

Flash forward past the dot-com collapse, the recession, 9/11 and the recovery, to Tuesday, Oct. 3, 2006. The Dow clawed its way to the highest level in its more than 110-year history, followed the next day by another record, and then another. There’s been no hat-tossing this time around, though. And the financial media made only passing mention of the landmark. True, for the talking heads on business television, 11,727.34 doesn’t exactly roll off the tongue like 10,000 does. But the tepid interest is the surest sign yet that the benchmark’s grip on investors might finally have waned. “It’s a bit of a throwback,” said Sonya Morris, a senior analyst with Morningstar Inc., a Chicago-based investment research firm. “In terms of a broad forward indicator of what to expect from the U.S. economy, the Dow really isn’t the metric to look to anymore.”

There’s no denying the Dow’s central role in the history of American capitalism, a notion its owner, Dow Jones & Company Inc., publisher of the Wall Street Journal, has carefully honed. Until Charles Dow, a high-school dropout-turned-journalist, came along in the late 1800s, most investors lived in the dark about the performance of the companies they owned. It was Dow who gathered and published the first stock tables and corporate financial records in the two-page Customer’s Afternoon Letter, the precursor to the Journal. And it was Dow who cobbled together a basket of “smokestack” companies to form the first stock benchmark to track the overall performance of the market. Investors have been glued to it ever since. As the Dow Jones website proudly proclaims, talking about the stock market without mentioning the Dow is “like talking about the weather without mentioning the temperature.”

Dow Jones certainly wants you to believe that, anyway. After all, since 1997 the company has made good money by licensing its 5,000 indexes as guiding benchmarks for investment products. For instance, the Diamonds Trust exchange-traded fund closely track s the movements of the Dow Jones Industrial Average and remains popular among retail investors. The Dow Jones Indexes/ Ventures division, which generated US$66.4 million in revenue last year, remains one of the fastest growing and most profitable parts of the company. So it’s no surprise the Journal, by far the most influential business publication in the world, treats the Dow as the pre-eminent measure of the U.S. market, giving short shrift to competing indexes.

Despite the free advertising from the Journal, there’s no shortage of reasons to explain the Dow’s apparent fall from grace. No. 1 is how it’s structured. While many investors think of the Dow as a broad stock index, it’s not. The Dow is an average price of just 30 stocks, with some minor tweaking. Every stock is given equal importance, no matter the size of the company. The Standard & Poor 500 index, a much broader and more representative reflection of the U.S. market, is calculated using companies’ market value rather than stock price. The S&P 500 still has 11.6 per cent to climb before it gets back to its March 2000 high.

Nor is there a shred of science in how the Dow’s 30 companies are picked. Over the decades, the editors of the Journal have occasionally huddled in an office somewhere to decide which names to add and drop from the Dow. At times their choices have seemed almost whimsical. In 1939, they booted IBM off the list, and didn’t bring it back for 40 years. Those years just happened to be the company’s fastest growth period, and if IBM had been included all along, the Dow would be far higher today than it is.

The editors’ anachronistic devotion to heavy industry represents the Dow’s biggest failing — it bears little resemblance to the modern U.S. economy. It wasn’t until November 1999, when Microsoft Corp. and Intel Corp. were added, that the Dow had any representation from the influential NASDAQ stock exchange, and there are still no Internet companies on the list. The Dow looks downright stale today. Take Alcoa, for instance. The aluminum producer can trace its roots back to wealthy industrialist Andrew Mellon, and when it was added to the Dow in 1959 it still controlled more than half of the U.S. market. Alcoa remains the largest aluminum producer in the world, but after last week’s merger of two Russian aluminum giants, the title is in jeopardy. In an era when the industrial names like Mellon and Carnegie have given way to Mittal and Deripaska, not to mention eBay and Google, the Dow’s Old Economy slant seems out of place.

It seems the smart money has moved on. Institutional money managers barely track the Dow’s movements. According to Morningstar, 84 index mutual funds in the U.S. are modelled on the S&P 500, with assets totalling more than US$184 billion. The Dow? One fund, a pipsqueak at US$10.5 million.

Still, the Dow has its defenders. Charles Carlson, contributing editor of the Dow Theory Forecasts newsletter, thinks the Journal’s editors have done a decent job picking the stocks in the Dow without getting caught up in any of the Internet bubble hype of the 1990s. “I know a lot of people like to badmouth the Dow, but they could have fallen into the trap and followed the crowd into all sorts of crazy stuff,” he says. Nor does he read much into the lack of attention given to the Dow’s recent high. If the Dow begins to close in on 12,000, which he predicts will happen this year, “people will get to thinking, ‘well, the train is leaving, I’d better get on board,’ ” he says. “That’s going to generate a lot more attention and energy. Those are the milestones that do pique people’s attention.”

In other words, the Dow’s value lies largely in its psychological hold on investors. Maybe the people at Dow Jones felt they needed to tighten their grip. A few months ago, Francis Gupta, director of research at Dow Jones Indexes, published a paper called “The Past and Present and Prologue to the Future of the Dow.” He called on readers to think of the U.S. as one giant corporation, and the Dow as its stock price. And using the last decade as a trend, “in the spirit of playing Nostradamus,” Gupta ventured a guess the Dow is headed for 34,821 in the year 2049. It’s just not clear whether anyone will notice.