Dow Jones Investment Opportunities
The Dow Jones Industrial Average. Is it a club run by mandarins
who carefully avoid volatile companies, or is it an antiquated,
undemocratic index that investors should dump? Michael Wilson examines
the evidence
What would you say to a friend if he told you that the best way
of measuring the political temperature in your country would to
be to ask its 30 most famous residents for their views, and then
compile an index that showed how they were feeling from day
to day?
You’d laugh at his naivety. We’re all democrats now,
you’d say, and everyone’s voice deserves to be heard.
Yet the odd thing is that this celebrity-poll idea is not so very
different from what we do every time we look up the world’s
most prominent stock market index, the Dow Jones Industrial Average.
Dow Jones Investment Opportunities And Corporate America
Let’s be blunt about this. The reason why the Dow is incapable
of telling us what’s really moving corporate America is that
it’s a tight little gentleman’s club with an exceedingly
high proportion of has-beens among its cosseted membership.
Its accountancy methods are suspect and its horizons have been blinkered
until very recently by an absolute refusal to accept that the world
is a changing place. Indeed, its very survival into the 21st century
is a towering testament to the power of inertia on the part of fund
managers worldwide.
Dow Jones Investment Opportunities & North American Stock
Yet the awkward fact remains that it’s still the Dow that makes
all the headlines whenever we look at the North American stock market
- and indeed, some of us are only dimly aware that more meritocratic
alternatives, such as the Standard & Poor’s S&P 500
industrial index, exist at all. This is particularly strange because
every other country except America has now gone over completely to
a more broad-based index system, such as London’s FTSE-100 or
Tokyo’s Topix index. Time to do the same, perhaps. The
case for the prosecution
What’s wrong with the Dow? First, tell us how many hours
you’ve got to spare? Shall we perhaps start with the stock
selection process? Unlike almost any other surviving stock market
index, the Dow’s 30 member companies are allowed in strictly
by invitation from the committee (established in 1896).
Although the membership list is updated every few years (the last
change was in 1999), its composition is still profoundly weighted
towards heavy industrial companies rather than the service industries
that create all the wealth in today’s America.
Dow Jones Investment Opportunities & Bethlehem Steel
It’s only been in the past three years that heavyweight losers
like Bethlehem Steel, Union Carbide or Goodyear Tire & Rubber
have been removed in favour of new-money movers like Citibank, Microsoft
and Intel. Wal-Mart, the world’s largest retail chain, faced
enormous resistance before it was finally admitted in 1997, replacing
the aged Sears and Woolworth.
But where, for example, is Cisco, the world’s largest manufacturer
of internet servers? Where is Sun Microsystems? Both companies would
easily qualify on the basis of their market size, but both are still
being left out in the cold.
Dow Jones Investment Opportunities - Standard & Poor's
There are no such problems at Standard & Poor’s, the Dow’s
main rival, where admission to the index is by market capitalisation
alone. At S&P, nobody ever asks whether a new company like Yahoo!
or Amazon or Cisco has the right sort of breeding to make a decent
member of the club - if it’s big enough to matter, it just gets
in because it’s important to America’s economy. And that’s
surely a better way to reflect the market. On second thoughts,
maybe we should concentrate our minds on the flaky weighting process
that underlies the Dow? No, don’t yawn, it’s important.
Most investors would be absolutely astounded to hear that the Dow
gets pretty well all of its weighting from the raw stock prices
of its member companies - and not from their market capitalisation,
as would be the case with any other major stock market index.
Under the Dow system, if my dollar share price is twice as high
as your share price, then I’m twice as important as you and
any change to my share price will move the Dow by twice as much
as yours. There are a few counterbalances made nowadays to allow
for the effects of stock splits (scrip issues) and the like, but
basically the weighting principle holds as firmly as it did in 1896.
Dow Jones Investment Opportunities & Your attention To The S&P
So why should you turn your attention to the S&P instead? First,
because it’s a sectorally broad index, consisting of every kind
of large company, regardless of its heritage. (Although on the whole
it prefers industrial, transportation, financial and utility industries.)
Second, because it’s properly weighted according to market capitalisation.
Thirdly, because its larger 500-company membership list simply
makes it a better basis for an index tracker or a futures contract.
It’s tempting to suppose that the Dow’s narrow 30-company
base will always make it highly vulnerable to the particular things
that happen to its individual constituent companies. But there are
still one or two arguments to be made in the Dow’s favour
- and, in the usual spirit of fair-mindedness, we ought to be prepared
to hear them.
Dow Jones Investment Opportunities & Yahoo
Consider, for example, the case of Yahoo!, the internet portal and
search directory whose value has slipped from US$94 billion in March
2000 to less than US$10 billion now. How thankful the Dow Jones committee
must be that it was never forced to let this raucous (but large) upstart
into its exclusive club. Unlike the S&P, where the tumultuous
infant duly did its destructive worst to the index. There’s
also the likelihood that a non-Dow index will always be more vulnerable
to changes in the bank rate, because its constituent companies will
borrow more from the banks than the cash-rich thirty in the Dow
club. They’ll also be more exposed to the corporate bond market,
so they’ll have to compete more vigorously against the rival
charms of alternative investments.
Finally, it’ll probably be more exposed to the hurly-burly
of the international trade market. Its member companies will rely
on the export markets more than the Dow’s 30 companies, which
are usually heavily US-oriented, so every twitch in the exchange
rate will affect them more.
Dow Jones Investment Opportunities - Stock Market Index
Why does it matter anyway? It’s odd how we simply take it for
granted that a stock market index is just a passive measuring device
like a thermometer, when in fact it’s capable of exerting a
real and active influence on the world around it. The next twelve
months are going to bring us plenty of proof that it makes a real
difference whether we choose the Dow, the S&P, or even a global
index like MSCI as our touchstone. You can blame the index
tracker fund industry for this. Index trackers, in case you haven’t
come across them yet, are the fastest-growing type of investment
vehicle among private investors, with up to
25 per cent of the US market and 15-20 per cent of the UK scene.
They’re now moving into continental Europe, and will be seen
in many emerging markets before long. They’re steady, they’re
reliable and their downside is limited by their sheer broadness.
The important point to remember about an index tracker fund is
that its manager has absolutely no discretion over which stocks
he buys. If he’s supposed to be tracking the Dow and one of
the Dow constituent companies rises tomorrow, then his computer
will order him to go out and buy that company’s stocks - because
his fund’s rules state that he must always keep up a perfectly
balanced weighting in all those companies, according to their weighting
within the index.
Dow Jones Investment Opportunities & Trouble
That’s when the trouble starts. Imagine what happens when
every tracker fund manager goes out and buys the same company’s
shares on the same morning. The market gets tight, then tighter,
then impossibly overheated as the demand drives up the price to
a ridiculous height. And then somebody starts selling, the price
drops and the whole index-tracking stampede goes into reverse.
Now imagine what happens when a company is unexpectedly demoted
from the Dow, or the S&P, or whatever. Suddenly, the whole world
is desperate to dump its stock so that it can hurl itself into the
company that’s just replaced it. (Remember that these managers
have no mandate to think for themselves, but are obliged to follow
the herd.) The company’s stock price bounces around quite
horrifically, for no better reason than that it’s been arbitrarily
placed in the spotlight.
Dow Jones Investment Opportunities - Hong Kong
We also need to consider the fact that many indices form the basis
for futures or options contracts - and that these derivatives also
have the capacity to bite the hand that feeds them. The reason why
Hong Kong’s stock market index crashed so spectacularly in 1987
was that Hong Kong was utterly loaded with options contracts based
on the Hang Seng. When the index faltered, the sheer financial leverage
that the options contracts had placed on it was enough to put the
skids under the underlying Hong Kong equities. And as they dropped,
they hit the Hang Seng so badly that they had to close the stock exchange
for nearly six weeks while they sorted out the mess.
Dow Jones Investment Opportunities & S&P
Of course, there will always be some investors who actually prefer
to steer their portfolios according to the medium-strength stars in
the constellation - on the reasoning that the very largest companies
are insulated by their sheer size from the things that affect ordinary
American companies, and that it’s better to stick with the mainstream.
They’re spoilt for choice. There’s the Wilshire 4500,
which includes every US stock except those which are already included
in the S&P 500. There’s the Russell 2000, that ignores the
biggest 1,000 companies in America and focuses on the next 2,000.
There’s the S&P 400, a medium-company index that tracks
the 400 largest companies outside the S&P 500.
And there’s the Schwab Small-Cap, which starts with the 1,001st
company and goes down to number 2,000.
To say nothing, of course, of the Nasdaq 100 (the 100 largest companies
on the almost exclusively technology dominated Nasdaq exchange,
but excluding financial companies); the Nasdaq Composite (the mid-cap
index on the Nasdaq that includes all the Nasdaq’s OTC stocks);
and so on.
Dow Jones Investment Opportunities And Abroad
And abroad?
As you’d expect, the Dow/S&P conflict has parallels in many
other stock exchanges worldwide. The UK has never quite got round
to abolishing the old FT 30 index, which resembles the Dow in all
the salient flawed points, but nowadays attention centres very much
on the FTSE-100 index, a fully weighted composite that includes the
100 largest companies by market capitalisation. Mid-market company
fanciers, on the other hand, find that their needs are catered for
by the FTSE mid 300 index, the FTSE AIM index, or even the All-Share
index (covering around 850 companies). Germany’s main index,
the DAX 30, is also a 30-company index, but it takes a different
approach to prioritising its constituent list. Instead of focusing
on sheer market size, the DAX makes its company selections by asking
which are the 30 most heavily traded stocks (based on the past three
years of data) on the Frankfurt exchange. This is an excellent idea,
on the whole, because Germany has the unusual problem of having
many very large companies that refuse to let more than 25-30 per
cent of their shares to float on the free market at any one time.
Dow Jones Investment Opportunities - The Free Float
The small size of the free float can create dangerous bottlenecks
when the shares are in demand by tracker fund managers, so Frankfurt
avoids a good deal of trouble by screening them out of its top 30.
Japan has a different problem. Its favourite index, the Nikkei 225,
is still the one that the newspapers favour, but it’s being
increasingly shunned by expert investors who say they get a better
overall picture from the Tokyo Topix instead - because the Topix contains
a better weighting of the stricken banks that count for so much in
Tokyo’s financial climate.
But many investors are now being attracted to the JPN, a DAX-like
index that tries to measure the most actively traded stocks on the
Tokyo market instead of merely the largest.
Finally, let’s turn to the truly international scene. You’ll
have noticed that increasingly we’re being urged to stand
back from the petty limitations of one national stock exchange or
another, and to invest our money globally instead, by backing companies
within particular sectors across a range of countries. But where
do you go for
the information?
Dow Jones Investment Opportunities - FTSE International
You can start with the renowned FTSE International indices (www.ftse.com),
which include around a dozen international and pan-regional indices.
Or try the Morgan Stanley Credit International (www.msci.com), which
are published daily on the internet. MSCI’s products include
a World index, a Europe, Australasia and Far East index, and a Select
Emerging Markets index, which tracks more than 600 stocks from 14
countries in Latin America, Europe, South East-Asia and the Middle
East. Don’t forget the Schwab International, which tracks the
350 largest publicly owned companies outside the USA. Obviously,
no one index can be perfect for everybody, But if you’re in
doubt, go for the broadest, best balanced, most diverse index you
can find. In a year when America’s economy is hitting every
kind of extreme, you’ll be better off sticking firmly with
the
mainstream and avoiding the biggest, the best and the brightest
just because they make for good headlines.
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