Down 600 points one day, up 400 points the next, down another 500 points a day later, then up 400 points the day after that — yes, the Dow Jones industrial average is back in the news. Charles Dowdevised the index in 1896 to give investors a snapshot of the performance of big manufacturing stocks (and of the U.S. economy) each day. The Dow still has an antique feel to it, but as a metaphor for the stock market, it remains unsurpassed: endlessly cited, parsed, followed, predicted — and misunderstood.
1. The Dow is an index of very large industrial companies.
Not anymore. The Dow’s components change every few years in an effort to reflect the breadth of the U.S. economy and to drop troubled companies. The 30 companies it currently comprises include four financial firms, two giant retailers, one restaurant chain, five consumer-products makers, two telecommunications firms, three drug companies, five high-tech firms and an entertainment conglomerate. There are only five traditional manufacturers— Caterpillar, Alcoa, United Technologies, 3M and the highly diversified General Electric — plus a couple of energy companies.
Nor is the Dow a collection of the largest U.S. firms. Among those missing are Apple — which lately has been trading places with Exxon Mobil as the biggest company in America — and Google, which has a larger market capitalization (the number of shares outstanding multiplied by price) than Wal-Mart, a Dow component. While Apple had a market cap of $347 billion, as of Tuesday, Alcoa had a cap of just $13 billion.
Even stranger is how the Dow is calculated. Most indexes, including the Standard & Poor’s 500, are weighted by market cap: Bigger companies affect the index’s value more than smaller ones. But the Dow is weighted by stock price — an arbitrary figure that has little to do with size or value. Both McDonald’s (market cap: $89 billion) and Intel ($109 billion) are part of the Dow. But because McDonald’s trades at $86 a share, it has more than four times the impact on the Dow’s movements as Intel, which trades at $21. IBM is the Dow’s top dog, with a greater impact on the index than Alcoa, Bank of America, Cisco, Intel, Pfizer, AT&T, GE and Hewlett Packard combined.
2. Movements in the Dow are driven largely by corporate data such as earnings and revenue.
If only it were that simple. The market value of the Dow, like that of any individual stock, is determined by a consensus view of buyers and sellers, who guess a company’s value today by trying to forecast what it will earn in the future. Those projected profits are influenced by all sorts of things, including domestic politics and the federal budget. And for the blue-chip companies that inhabit the Dow, the overall performance of the U.S. economy may be most important of all.
In that sense, the losses and volatility of recent days can be viewed as a result of investors’ reassessments of America’s long-term growth prospects. Instead of the 3 to 3.5 percent growth rates that the economy has averaged since World War II, we are facing rates a full point lower, or worse, now and probably in the future. Of course, the government might take steps to boost growth — reforming the tax code, for instance, to encourage more investment; or changing immigration policy to attract smart, entrepreneurial foreigners; or seriously chopping wasteful spending. But for now, the markets seem to be adjusting expectations downward.