The Dow Hit 40,000. It Doesn’t Matter

The Methodology Is All Wrong

The Dow is technically not an index but an average of prices. A great technical breakthrough when it was introduced by Charles Dow late in the 19th century, the stocks that are in it are weighted according to the price of one of their shares — not the total value or market capitalization of each company’s shares.

This leads to some bizarre weightings. The following chart ranks the 30 stocks now in the Dow by their percentage weight in the index, and also shows the weight they would have if they were instead weighted by market capitalization. The divergences are extraordinary:

There is reasonable concern about the way the Magnificent Seven tech platform stocks have come to dominate mainstream cap-weighted indexes. Therefore, arguably, there might be something appealing about the way the three Mag Seven stocks currently in the Dow — Microsoft, Apple and Amazon.com — are all greatly underrepresented compared to their total size.

What’s plain daft, however, is the way some companies are given far bigger weightings because of a high share price. UnitedHealth Group Inc. and Goldman Sachs Group Inc. are the two biggest Dow components, for some reason, while the likes of Caterpillar Inc., The Home Depot Inc., Amgen Inc. and Boeing Co. are also overrepresented. Meanwhile, Walmart Inc., now worth more than $500 billion after its latest good results, is underrepresented. If there were some underlying logic to the allocation, that might help. Indexes based on fundamentals like dividends, earnings or revenues make a lot of sense. Giving them all a 3.3% weighting might say something. But pricing them on this basis is pointless.

The Membership Is Wrong

At one point, the Dow was a spread of the largest companies in each of the big industrial sectors. Once in, a company would stay there until it was bought or came to the point of bankruptcy. Being admitted to the Dow was taken as a badge of honor for a company, while being dropped was a humiliation.

Now, the members seem to be chosen as part of an attempt to reverse engineer the index so that its performance will be as close as possible to the S&P 500 (which is far and away the most influential index to which much money is tied). That leads to some indefensible calls. Among chip makers, Intel Corp. (market cap: $136 billion) is a member but Nvidia Corp. (now worth $2.3 trillion) isn’t. Chevron Corp. ($297 billion) is the representative of oil companies; ExxonMobil Corp. ($528 billion) has been dropped.

Putting the problems of poor methodology and poorly decided membership together, the following chart shows which stocks have contributed the most and least points to the Dow since it first hit 20,000 in January 2017. Apple Inc. on its own contributed more than 3,000 of those points, but the other biggest contributors are a strange collection.

Meanwhile the companies that actually subtracted points from the Dow over the last seven years have in several cases been dropped from the index during that period. This applies to two of the index’s longest-standing members, ExxonMobil and General Electric Co. That leads to a further problem.

There’s Too Much Discretion

There is no fixed formula or general guideline as to which companies should be included. The selection committee has broad discretion and often cuts big companies from the index when they have been underperforming, sometimes missing out on a big rebound by a stock. This opens it to the issue of survivorship bias, which bedevils all indexes to a greater or lesser extent. They tend to be indexes of winners, which can be misleading.

In recent years, the discretion enjoyed by the selection committee has morphed into the classic problem that market timing is really, really hard. That shows up most dramatically in the decisions to drop General Electric, for long the biggest and most acclaimed company in the US, and ExxonMobil. GE was dropped in 2018, as its long and protracted fall after the exit of Jack Welch in 2000 became acute. Exxon left in the pandemic summer of 2020, when oil prices were on the floor. Although neither is still in the Dow, both contributed to lost points since it hit 20,000. Dropping them crystallized those losses, and meant the index missed out on their subsequent resurgence:

When so much can rest on a few discretionary calls, it’s hard to see why we should care about the index as a whole. The index committee isn’t supposed to be picking a winning portfolio, but at times it looks as though they are. As so often happens to active traders, that makes returns worse.

There’s No Money Riding on It

In the age of passive investing, the biggest reason to follow stock indexes is that they have come to matter. Choices over which companies or countries to include in the most popular benchmarks drive flows of billions of dollars. Compiling an index is no longer passive. We write so much about the S&P 500 and the MSCI Emerging Markets because they really, really matter — not just for the passive money tied to them directly, but for the influence they exert over the many active managers who are benchmarked to them.

On this basis, it’s not clear we should much care about the Dow. Its use as a benchmark for active managers is minimal — as in I’ve never met an equity manager who used it as a target. There is an exchange-traded fund that tracks it, offered by State Street, which also offers the behemoth S&P 500 index ETF. The Dow ETF holds $34 billion. The S&P ETF has $525 billion. When the S&P decides to admit high-flying companies like Google or Facebook , it’s an event with real ramifications. Fiddling at the margins of the Dow doesn’t matter.

Since the Dow ETF was launched in 1998, incidentally, its market cap has fallen steadily further behind the S&P 500 — although thanks to the strength of the US stock market and the growing popularity of indexing, both have snowballed in remarkable fashion. This is how the two have grown since then, indexed to the launch of the Dow fund:

Indexes matter more than ever. They frame and lead the investment world. But the Dow doesn’t. And despite the journalistic assumption that mom and pop investors are still more interested in the Dow, that is contradicted by the evidence of where they actually allocate their dollars.

The Results Don’t Tell Us Much

It has taken the Dow a little over seven years to double since it hit 20,000, during the first week of Donald Trump’s presidency in January 2017. Its underweighting in the big tech platforms that have dominated growth since then means that it lags the S&P 500 by more than 25 percentage points since then — although it has managed to come close to replicating the result of the equal-weighted S&P 500, in which each constituent receives a weighting of 0.2%.

As in practice it does behave quite a lot like the equal-weighted S&P, it’s worth looking at what might have driven its performance. One measure almost as old as the Dow itself is to gauge the stock market by comparing its performance to gold. Stocks gain with optimism and gold with pessimism to create a balance; and as gold is regarded as a measure of confidence in the currency, the stocks/gold ratio can also give an idea of how much appreciation is due to monetary debasement rather than corporate growth.

When denominated in gold rather than dollars, it turns out, the Dow has been almost exactly flat since it first hit 20,000:

Since the pandemic, and for all the increases in interest rates in the last two years, it does look very much as though it is liquidity and money creation, rather than anything else, that has driven the Dow to its latest record.

Perhaps more reassuringly, the pace of its ascent isn’t exceptional. The last doubling has seen the Dow rise at an average annualized rate of exactly 10.0%. Prior to that, the doubling from 10,000, set in the spring of 2019, had been made painfully long by the implosion of the dot-com bubble and then the global financial crisis. Over those 18 years, it averaged 4.02% growth. That followed the remarkable ascent of the late 1990s, when it doubled in a little over three years, compounding at more than 20% per annum.

Overall, it’s difficult to see much impact from each of the milestones, for all that they are accompanied by celebratory baseball caps and T-shirts. Big landmarks have come shortly ahead of big crashes (in 1987 when it topped 2,500 and again in 1999), but they’ve also helped provide octane as when it reached 5,000 in 1995 or, to a much lesser extent, when it hit 20,000 in 2017. But there’s no obvious impact from hitting milestones.

At the moment there seems to be a Pavlovian reaction to Dow landmarks. Journalists and analysts believe that people will be interested. They never explain just why anyone should be interested, or even care. If anyone out there finds information or guidance in the Dow that they can’t get elsewhere, do tell.

Survival Tips

I have been attacking the Dow like this for years, and it never has any effect. Instead I’ve been likened to Don Quixote tilting at windmills, or Captain Ahab chasing the great white whale. Fair enough, Don Quixote and Moby Dick are both really good, and they both inspired Orson Welles. Meanwhile, when I linked to the Beatles’ Now and Then at the top of this piece, I was reminded that it’s deeply moving. The song and the video, both of which would have been impossible without artificial intelligence, make the strongest argument I’ve seen that AI can be a force for good. It could do harm in the wrong hands, yes, but anything that allowed the two octogenarian Beatles to play once more with their long-dead bandmates is a wonder. It’s worth watching. Enjoy the weekend, everyone.

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Bloomberg News provided this article. For more articles like this please visit bloomberg.com.

Read more articles by John Authers