Dow Jones Industrial Average

Abron Toure By Abron Toure, 21st Jun 2010 | Follow this author | RSS Feed | Short URL http://nut.bz/mjupyyu-/
Posted in Wikinut>Money>Investing

The DOW Jones is made up of 30 companies out of 3,615 on the NYSE. The index is not one of diversification but made up of stocks from companies most widely held in the country.

How Useful is the Dow Jones Industrial Average?

The DOW Jones Average is made up of 30 companies on the New York Stock exchange. As of January of 2009 there were 3,615 companies listed. In March of 2006 the NYSE had a market capitalization valued at $43.6 trillion dollars. Market Capitalization equals the stock price multiplied by the number of outstanding shares. Outstanding shares refer only to the public side of the company and therefore only measured public failure or success not what may be held privately in the same company.

In March of 2008 the New York Stock Exchange market capitalization was valued at $27.3 trillion dollars. Today the estimated value is $15 trillion dollars. Since some say there is only $7 trillion dollars of money in the United Statesone might wonder where did the other vast sums come from or go to for that matter? Of course that money is just on paper and one can see how easy it is to evaporate and re-materialize wealth almost whimsically.

As mentioned the DOW Jones is made up of 30 companies out of 3,615 on the NYSE. Not to mention the other 7,000 technology-Nasdaq, transportation and utility companies in the United States that are not represented. This means that the concept governing this index is not one of diversification even though the Dow is made up of stocks from companies most widely held in the country.

All 30 of these companies with the exception of Intel and Microsoft, (They are a part of the Nasdaq.) are members of the New York Stock Exchange. In fact only due to a recent change in the rules, which precluded non NYSE members, allowed their inclusion. The fact these companies are some of the most widely held stocks are one of the few pros that seem to stand-up to why they could possibly be used as a true indicator. Yet there are many more reasons why they fail to give us a true picture what the real market is doing. Here are some of the many cons.

First, the DOW Jones Index is a price weighted average. This means that the higher value stocks are given more weight than the lower priced stocks. Or put another way smaller companies on the DOW can have and often times do have a bigger impact on the index than larger companies. Thus the weighted average has nothing to do with the companies overall size. That means if the more expensive stocks are doing well than the index is doing well and visa versa.

The Dow works by establishing a divisor based on the weighted average. Once the divisor has been calculated the percent change is muted. So a $1 decrease in value of a stock worth $10 per share or $1 decrease in value of a stock worth $100 per share is indexed the same. So the average is not one where you can add up the price of 30 stocks and then divide by 30.

There is also another calculated caveat. If any one of the stocks splits the average will remain the same. The index does not change instead the price and divisor, are adjusted. Thus price of a stock goes down as a result of the spilt but the indicator stays the same. These are a few mathematical manipulations of the index. Yet there is a bigger question and it has little to do with the math.

Based on the quality and strategy of the 30 stocks picked, the question, is the DOW Jones Average a good representation of how the market is actually doing? Or stated another way, how can a market such as the New York Exchange and the broader markets in general justify such psychological wealth being evaporated based on the volatility of 30 companies?

It starts with this sticking point. The divisor is adjusted only when there is a recalculation of the price weighted average. This is done when stocks are rotated in and off the roles of the DOW. Here’s how it is works.

The method of selection for these 30 companies is conducted through an annual review process done by Dow Jones & Company perhaps in conjunction with the Wall Street Journal. They use seven criteria to decide what companies should stay and which ones should go.

Essentially a public relations strategy, the index is designed to put the best face on Wall Street. The process is about establishing what is called The Dow Jones Sustainability Index and it is design to make sure only those corporations that represent the top 10% of the leading sustainable companies in a given industrial sector are represented.

The first criteria, is classified as Sector Sustainability. The companies are reviewed with respect to their primary revenue source. In the case of Bank of America, Citigroup, GM and JP Morgan Chase & Co their main source of income is now the tax payer! These sources of income and sectors are judged on their ability to sustain a certain level of performance.

The second criteria, is Corporate Sustainability. Each company is required to be evaluated. The results are tallied and a score assigned. Here the focus is on shareholder value, company management, economic goals and the company’s relationship with the community. For example, has the company always paid a dividend and how much. It is essentially a risk assessment. The survey of the company is as much subjective as objective.

Third the company is given a ranking within the Sector. This is based on the Corporate Sustainability score.

Fourth is the Eligible Industrial Groups. This primarily is an evaluation of the sectors in conjunction with the corporation. Only those companies that rank a high percentage of the maximum score in a given sustainable sectors can earn further consideration.

Fifth is Eligible Companies. Those sectors and corporations qualifying under the forth criteria, companies that are in the top 50% percentile of a sector are eligible for further consideration.

Sixth is the Component Selection. Overall the top 10% companies are selected. Then from each sector based on the corporate sustainability score the top 7% of the companies per sector are selected. If the required number is not reached by then the top 10% in a sector are selected. If still the required number is not reached then the standards are lowered until the desired amount has been reached.

Seven is the Market Capitalization Coverage. The DJSI establishes a free floating target market capitalization for each subsector. This floating capitalization number is based on a percentage of the market capitalization of a larger super sector. If companies exceed this market capitalization then they are selected. If the required number is not met after this iteration then the floating target market capitalization number is adjusted down.

This process is of course very detailed and much more technical than the length of this article permits. None the less the review takes place annually and sometimes quarterly as needed. The point is Dow Jones & Company go through this elaborate process to put the best face possible on the market. Since the Dow Jones Industrial Average is the most recognizable index in the world. The controversy about whether it adequately represents the real market is the point and it is a hotly debatable.

In March of 2008 the Dow Jones market capitalization was less than 10% of the New York Stock Exchange. Under some circumstances 10% might work as a good indicator. But keep in mind the NYSE does not include The Nasdaq, Transportation, Utilities, Preferred Stock, or privately held companies. Then there are the dubious companies, a part of the DJIA like Citigroup and General Motors. Is it a wonder people are beginning to ignore the Dow Jones all together and the world is looking for a suitable replacement based on a combination of US, Euro and Asian copulations.

Tags

Market Capitalization, Nasdaq, New York Stock Exchange, Nyse, The Dow Jones Average

Meet the author

author avatar Abron Toure
Abron Toure has a BA in Philosophy, Brandeis, a BS in Chemical Engineering, Northeastern, MS Administration, Boston University. worked for Raytheon, Lam Research and Tokyo Electron Limited.

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author avatar drelayaraja
26th Jun 2010 (#)

Nice share

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