Originally created 04/02/04

Does the Dow accurately reflect the market?



NEW YORK -- Can 30 stocks accurately reflect the entire U.S. stock market?

Since its inception in 1896, the Dow Jones industrial average has been the public's foremost gauge in determining how U.S. stock markets perform. But for many investment professionals, the Dow was long ago supplanted by other, more comprehensive or precise indexes.

The Dow is certainly Wall Street's lingua franca with the investing public. But investment strategists feel the index, with just 30 stocks, may not be a solid basis for determining the course of a market consisting of tens of thousands of stocks.

"I do track the Dow, because it makes it easy to talk to clients about the direction of the markets, said Hugh Johnson, chief investment officer at First Albany Corp. "But I'd never use the Dow for any kind of economic or financial analysis."

Most professional investors, traders and analysts see the Standard & Poor's 500 - a group of 500 of the largest U.S. companies, as a far better benchmark of the overall stock market. For one, its broader base of stocks means that unusual circumstances at a single company won't unduly affect the overall index.

For another, it's an easier benchmark to use to measure performance of mutual funds. While most funds include at least some Dow components, they also include thousands of other stocks not part of the Dow.

Dow Jones Indexes editor John Prestbo defended the relevance of the Dow Jones industrial average, however, noting that it has closely tracked the S&P 500, with a correlation of .95 since World War II.

"Sometimes we're asked, how can you track the U.S. market with just 30 stocks?" Prestbo said. "The Dow has been composed of stocks chosen for their representation value, not their investment prospects."

The 30 stocks, Prestbo said, are chosen to represent the strengths and weaknesses of the overall U.S. economy, not just the stock market or individual sectors. The editors of The Wall Street Journal select the Dow components.

The three companies removed from the Dow Jones industrial average in a periodic shuffling Thursday - AT&T Corp., Eastman Kodak Co. and International Paper Co. - saw their shares fall in trading, while the new Dow components due to join the index April 8 - Pfizer Inc., AIG Inc. and Verizon Communications - saw strong gains in their stock prices.

If nothing else, it shows the power that the Dow has in the minds of many investors, especially since nothing has fundamentally changed with regard to those companies' financial health. But even Prestbo said inclusion in, or exclusion from, the Dow will have little long-term impact on these companies.

"We've really only seen temporary price changes when stocks are added or subtracted," Prestbo said. "After a while, everything reverts back to 'What have you done for me lately?"'

Removal from the S&P 500 is a far worse prospect for any company, according to Brian Bruce, director of global investments at PanAgora Asset Management Inc., because nearly every major brokerage house manages billions of dollars tied to index funds based on the S&P 500. If the S&P 500 composition changes, those funds alter their holdings accordingly.

"Moving in and out of the Dow is a lot different from moving in and out of the S&P 500, because of all the index dollars that must follow you," Bruce said. "There are not a whole lot of indexes following the Dow."

AT&T, Kodak and International Paper all remain part of the S&P 500. Pfizer, Verizon and AIG are also part of that index, managed by Standard & Poor's McGraw-Hill subsidiary.

So, with the greater accuracy and market-moving power of the S&P 500, why does the Dow remain Wall Street's single biggest gauge for the stock market?

"I think the Dow has become a part of the lore of Wall Street, the Wall Street culture," Johnson said. "It's something everybody's come to know about. It's the common denominator for talking about stocks."