Why the Dow Jones hitting 20,000 is meaningless
As economic indicators go, the Dow is a deeply flawed one, experts say
There are few things economic experts agree on. That the Dow Jones Industrial Average is ridiculous as an economic indicator is one. That its milestones are meaningless is another.
For weeks now, headlines have been breathlessly anticipating the Dow breaking through the 20,000-point mark. Never mind that the much broader S&P500 has hit new all-time highs since Donald Trump was elected, as has the technology-focused Nasdaq — it's usually "the Dow" that claims top billing in newscasts and business pages.
It finally passed the milestone on January 25th, and was met with more of the same.
And yet, just about everyone who knows anything about it will tell you it is a deeply flawed, overly simplistic, wildly inaccurate measure of either the economy or stock markets.
'It just happens to be wrong'
"It's actually a pretty bad metric," says John Shoven from the Stanford Institute for Economic Policy Research. "It's poorly constructed. Its only claim to fame is that it's been around for 120 years."
Before we even tackle the arcane way the Dow is calculated, let's address the milestone.
"It's just a round number," says Shoven, who has criticized the Dow and our obsession with milestones in the past. "There's nothing more significant about it crossing 20,000 than when it crossed 17,500 or any other number."
Every time it goes up, it hits a new all-time high; we arbitrarily celebrate some more than others. When you look at the Dow's methods, things get even muddier.
The Dow puts 30 big-name U.S. companies in a basket and adds up the total dollar value of all those stocks. It doesn't adjust for inflation.
The Dow has its own divisor, a figure it uses and changes over time to try to adjust for stock splits or spinoffs. As such, it gives more influence to expensive stocks. So if two companies are worth about the same amount, if one has fewer shares that are worth more, that company has an oversized influence on the average.
"It's simple," says Shoven. "It just happens to be wrong."
Math was really hard — in 1896
And why, you may ask, does a major stock market index use such a simplistic method? Because when the index was created back in 1896, computers didn't yet exist.
"The Dow Jones is just a relic from old days, when computation was difficult," says Ronald Balvers, professor of finance at the DeGroote School of Business at Hamilton's McMaster University. He says the Dow is built the way it is because that was the easiest way to add things up 120 years ago.
That basket of 30 companies has traditionally been something of a relic, as well. Apple was only added in 2015. General Electric has held a spot since 1907. Proctor and Gamble's been listed since 1932 and Dupont since 1935.
Balvers says that means the index offers a limited scope into market activity.
"We're not including bonds, we're not including real estate, we're not including small companies, so from that perspective it's a bit of a very select measure of the performance of financial markets," Balvers says.
It's misleading, too
Worse yet, Shoven says, the Dow does not include dividends. So it doesn't come close to reflecting total returns for shareholders. If the Dow had added dividends back when it overhauled the index in 1928, it would be approaching a very different milestone today.
"If you had the total return index," he says, the Dow "would be well over 500,000 today, approaching a million. On the very long run, it's off — it's way off."
So keep all this in mind as you are inundated with blaring headlines about the Dow breaking through 20,000. It is a snapshot of a particular group of stocks and it provides some limited historical context.
What the Dow does do is show a very broad trend in stock markets.
"I would say it is right directionally," says Shoven. "It indicates that stock prices have gone up over the long haul — and indeed they have." The Dow is up, as is the S&P 500 and almost every other North American stock index.
But the whole point of an index like this is to help us understand something about the stock market and about the state of the economy at large.
And on that, the Dow is an indisputably lousy indicator.