FINANCIAL MARKET UPDATE 8.25.2020

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

IGNORE THE DOW

Late yesterday it was announced that the Dow Jones Industrial Average (Dow) will be undergoing a major facelift. The update was prompted by Apple’s decision to undergo a 4-for-1 stock split, a move that would have materially altered its composition. As a result, the committee that oversees the index elected to make some adjustments to mitigate the impact. This includes dropping Exxon Mobil, Pfizer, and Raytheon technologies, and replacing them with Salesforce, Amgen, and Honeywell. Exxon Mobil had been in the Dow for 92 years. While this news is getting a lot of airtime in the financial media, and I just wasted a paragraph summarizing it, this is not important news.

While the Dow remains popular with many individual investors and is commonly quoted in the media, it is severely outdated and inferior to many other gauges for the U.S. stock market. For this reason, most professional investors focus their attention on indices that are more comprehensive and better designed, such as the Russell 3000 or the CRSP US Total Market Indices. One drawback here is that these indices are not commonly quoted in the media. The S&P 500 offers the next best, albeit imperfect option.      

The Dow was created in 1896 by the editor of the Wall Street Journal and co-founder of Dow Jones & Company, Charles Dow, and his partner Edward Jones. It is the second longest-running market index in the United States, trailing only the Dow Jones Transportation average, which began in 1884. Compared to today, the makeup of the economy was dramatically different in the late 1800s, with railroads and other transport companies comprising roughly 50% of the stock market at one point, hence the development of the transportation index first.

The Dow is vastly inferior to modern indices for a variety of reasons. The most glaring criticism is the method it uses to weight the constituents. Broadly speaking, the two most common approaches weight companies based on price or market capitalization (market cap).

  • Price Weighting: Company weights are determined by the price of an individual share.
  • Market Cap Weighting: Company weights are based on the actual market value, calculated as the share price times the total number of shares outstanding.

The table below provides a hypothetical example to illustrate how the results differ between the two methods. Since Company A has a much larger share price ($90), it gets a correspondingly larger weight than Company B in the price index (90% vs. 10%). Company B, however, has significantly more shares outstanding, and its total market value (10 x 3,600 = $36,000) is approximately double Company A’s. Clearly, the price index is not accurately reflecting the relative size of the two firms.

 

In the late 1800s, weighting by share price was a simple and straightforward way to calculate an index. The advent of computers, however, made the market cap methodology feasible. Not only does market cap do a better job of reflecting the true relative size of index constituents, but it also handles corporate actions like stock splits better. While Apple’s 4-for-1 split has no impact on cap-weighted indices like the S&P 500, it has a profound impact on the Dow. Apple is currently the largest weighted company in the Dow by far but will fall to the 17th position overnight once the announced index changes are made.

Another common criticism of the Dow relates to its high concentration. The U.S. stock market is comprised of thousands of companies. The best representation of how the market is performing would be an index that tracks all of them. Meanwhile, the Dow only tracks thirty firms. Although it is diversified across sectors (excluding transports and utilities), it still omits a meaningful amount of the market, which can lead to dramatic performance differences over time. This critique can (rightfully) be applied to the S&P 500 as well, however, it covers more than 80% of the market and is the most comprehensive gauge among those commonly quoted in the media.   

In today’s world, where crunching numbers and sharing information are extremely easy, there is simply no reason for a back-of-the-napkin approach like the one used by the Dow to garner so much attention. Investors are better served by ignoring the Dow and focusing on other more comprehensive gauges of the market. 

WEEK IN REVIEW

  • The S&P 500 has recently joined the Nasdaq in pushing to new all-time highs in recent days and closed above 3,400 for the first time yesterday.
  • Investor sentiment was buoyed early this week by the FDA’s emergency use authorization of convalescent plasma for the treatment of COVID-19. Positive developments related to the pandemic have consistently boosted stocks higher, particularly those in the hardest-hit segments of the market.
  • Last week initial jobless claims moved above 1 million after briefly declining below that level. Later this week, look for updates on durable/capital goods (Wednesday), initial jobless claims and a revised estimate of Q2 GDP (Thursday), and inflation and a potentially important speech by Fed Chair Powell in Jackson Hole (Friday).

HOT READS

Markets

  • Powell Set to Deliver ‘Profoundly Consequential’ Speech, Changing how the Fed Views Inflation (CNBC)
  • Coronavirus Lifts Government Debt to WWII Levels-Cutting It Won’t Be Easy (WSJ)
  • Home Prices Show Signs of Recovery, Rising 4.3% in June, According to Case-Shiller Index (CNBC)

Investing

  • The Cost of Anticipating Corrections (Swedroe)
  • This Fund Is Up 7,298% in 10 Years. You Don’t Want It. (Zweig)
  • Reasons Not to Be Cheerful (James Montier)

Other

ECONOMIC CALENDAR

Source: MarketWatch

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

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ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

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JOSH JENKINS, CFA + SENIOR PORTFOLIO MANAGER & HEAD OF RESEARCH

Josh Jenkins is a Senior Portfolio Manager & Head of Research at Lutz Financial with over nine years of investment experience. He is responsible for assisting clients in the construction, selection, and risk assessment of their investment portfolios. In addition, Josh will provide on-going research and trade support.

AREAS OF FOCUS
  • Asset Allocation & Portfolio Management
  • Investment & Market Research
  • Trading
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst (CFA)
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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