All Things Being Relative

by Timothy D. Carkin, CAIA, CMT
Senior Vice President

All Things Being Relative

The slow creep higher in the markets continued this week. The S&P 500 finished the week up 0.12 percent with financials stocks leading the way, up 2 percent. The ADP jobs report on Wednesday and the non-farm payroll today gave us “not too hot, not too cold” readings. The bond market reacted with a yawn moving the 10-year U.S. Treasury yield 2 basis points to 2.26 percent. With a light load of economic news, the markets looked to company earnings for guidance. Apple’s third quarter report was impressive but didn’t carry through to the broader market. It did, however, contribute considerably to the Dow Jones Industrial Average breaking through another milestone, closing above 22,000.

Does the Dow Matter?

Over the last 10 days the widely watched and quoted Dow Jones Industrial Average (DJIA) outperformed the S&P 500 by 2 percent. Most people think of the two as interchangeable representations of large capitalization companies. To understand the difference, you must consider how the indices are constructed and why.

To start, a little history. Charles Dow, founder of the Wall Street Journal, and his associate, Edward Jones, created the Industrial Average and the Transportation Indices for their paper to illustrate how the largest companies of the time performed. Their assertion is that a small subset of companies could give the average investor a look into the economic health of the country. At its inception, the Industrial average consisted of 12 companies. At the time, these companies were carefully selected to represent the major sectors of the economy. The Wall Street Journal was a pioneer in publishing stock and index information but even they were limited on the information they had. As such, the most prudent way to construct an index was to weight it by price. Simply put, higher-priced stocks had a higher weight. For example, if a $100 stock and a $20 stock both rose by 10 percent, the index would be more influenced by the $100 stock move even if it's market capitalization were smaller than the $20 stock. Further, as stocks rally, their index weight goes up as well, pushing the good performers to the top. The Dow Jones Indices are the longest running in the U.S. but the only major indices weighted by price. Currently, the most common index methodology is market-value weighted.

Over the past two weeks, two high-priced blue-chip stocks, Boeing and Apple, have reported stellar earnings driving the stocks up. Boeing, which is the largest stock in the DJIA at 7.4 percent, rallied 13 percent on their quarterly earnings report. Boeing, the 35th largest name in the S&P 500, only moved that index modestly. It took the DJIA 107 days to go from 21,000 to 22,000 and 380 of those points came from Boeing alone. Apple is the largest weight in the S&P 500 due to its status as the largest company, but as explained it the above example, the impact on the price-weighted DJIA was much greater.

The DJIA has lasted for more than 120 years in part because it’s published every day in the leading financial journal. But is this the best benchmark for judging investment performance? The Dow Jones Industrial Average was created as more of an economic indicator, looking at a broad swath of sectors but picking single companies to represent them. Today this is accomplished by the Dow Jones committee which decide the constituents of the index.

When it comes to judging the performance of the broader equities market, we use market capitalization weighted indices like the S&P 500, which represents around 500 of the largest companies in the United States. Each company gets a weight associated with their market capitalization rather than price. This gives you a broader, more diverse representation of the market with less single stock and outside influences. Most institutional money managers make a similar determination, but the financial press has grown up quoting the Dow Jones and it will likely not change any time soon.

Takeaways for the Week:

  • Dow is a price-weighted index of 30 stocks
  • For large cap stocks, our benchmark is the S&P 500, a market-cap weighted index