Putting The Dow In Perspective

By Stephen D. Simpson, CFA | May 03, 2010 AAA
Putting The Dow In Perspective

The Dow Jones Industrial Average (DJIA) is inescapable. No matter how middling a news outlet's coverage of business may be, it is a safe bet that the performance of the DJIA or "the Dow" will be offered up as a comment on how the market is doing.

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What is often lacking, though, is a sense of context and significance. Without a bit of perspective on just what the Dow is, it's not that useful to talk about moves in the index, particularly when those moves are talked about only as points.

The Dow
Unlike the S&P 500, the Dow is a price-weighted index. This means that the stocks in that index includes stocks based upon the proportion of the stock prices, so a stock trading at $100 carries 10 times the weight of a stock trading at $10. This is notably different than the market-weighted index methodology (like the S&P 500) where the individual stock prices are irrelevant outside of their impact on the individual companies' market values. This is important to remember because strong performance from those stocks carrying a big nominal dollar price can swing the index more than the stocks that carry lower prices. (Read How Now, Dow? What Moves The DJIA? to find out how this index tracks market movements - and where it falls short.)

A Little Perspective
One of the odd things about the reporting of the Dow's performance is how often reporters and commentators refer only to the number of points the index has moved up or down. There is a psychological reality at work here; if a casual observer hears that "the Dow dropped 400 points", there may be a few moments of heart palpitations and the observer may stay tuned. On the flip side, if the talking head says "the Dow dropped 3.6% today," many more potential viewers may just tune it out, because "3.6%" does not sound like anything so impressive. After all, who comes home and brags that they negotiated a 3.6% raise from their employer?

Clearly this sense of scale is important. An owner of Sirius (Nasdaq:SIRI) is going to feel much differently about a one-point move in that stock than an owner of IBM (NYSE:IBM). Likewise with stocks like Apple (Nasdaq:AAPL) or Google (Nasdaq:GOOG). News presenters love to talk about 10-point moves in these stocks, but just happen to leave out the broader context that, on a percentage basis, the moves just are not that large or significant. (Learn more about the importance of the Dow in Why The Dow Matters.)

What the Dow Has Done
It is all but impossible to make sense of where the Dow is going if you lose sight of where the Dow has been. Much is made of the strong rebound we have seen since the depths of the credit crisis, and it is true that the move from an intraday low of 6469.95 on March 6, 2009 to the close on Monday April 27, 2010 at 11,205.03 has been impressive.

But even more impressive was the drop from the intraday high of 14,198.10 on October 11, 2007 to that low. That was a 54% drop, and while we have seen a 73% rebound, we still need another 27% move to get back where we started. In a normal year, 27% would be an exceptionally strong year, and it is probably reasonable to expect that it will take at least two years to make that move. So when people talk about the impressive rebound in the Dow, just keep in mind that there is still quite a ways to go before we are back where we started.

The Specter of Inflation
There is one other factor that should be considered when talking about long-term moves and long-term records with any stock index, and that is the impact of inflation. Inflation is ever-present and more significant than many investors realize. Consider the following: a stock index could rise by 3% like clockwork every year and the chart will look gorgeous and investors in that index will feel quite proud of themselves. But if inflation has been moving along at 4% every year, the true shape of that index's performance is quite different; every year an investor has held that index, they have lost 1% of actual value.

Why does this matter? Well, if you go back to 2007 and look at the Dow in the context of inflation, the Dow never reached that lofty high of nearly 14,200. In fact, the inflation-adjusted high back in 2007 was slightly below the record set in 2000. (Learn more about inflation in our Inflation Tutorial.)

The Bottom Line
That does not cancel out the nice rebound we have seen, nor does it eliminate the amazing run that the Dow had in the 1980s and 1990s. What it does mean, though, is that you cannot talk about the Dow in a meaningful way if you do not keep the index in its proper perspective.

Still feeling uninformed? Read this week's financial news highlights in Water Cooler Finance: Buffett's Armed and Greece Keeps Falling.

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