Both the S&P 500 and the Dow Jones Industrial Average are indexes that measure large-cap stocks. It would seem that they should track each other rather closely so it is interesting that the Dow has increased only 3.4% so far in 2014 while the S&P 500 increased 8.4%.
— Bespoke (@bespokeinvest) July 1, 2014
From the front page of Yahoo! Finance to CNBC to money news on the radio, the Dow is perhaps the most frequently cited and most famous stock index. Dating back to 1896, the Dow owes its fame today from being old. It was the market for decades after its inception and was still a key index through the middle of the previous century. It is a simple index – comprised of 30 hand-picked blue chip stocks – that has been computed the same way for 118 years. For comparability’s sake, the methodology of the Dow will never be changed. That methodology is also what makes it a flawed index.
The Dow is a price-weighted index while most other widely followed indexes, like the S&P 500 and the Russell 2000, are weighted by market capitalization. Weighting by market cap is a more accurate way to measure the market as it takes into account the size of the companies in the index. As Apple showed with its 7-to-1 stock split in June, firms can manipulate the price of their stock by controlling the number of shares outstanding. Before its split, Apple would have had 7 times the pull on a price-weighted index as it did post-split even though its market value never changed.
Being weighted by price sacrificed about a percentage point of the Dow’s performance – it would have shown a 4.3% return had it been market weighted rather than its 3.4% price-weighted return.
The price-weighted methodology is not the only reason the Dow has lagged the S&P 500 this year. As mentioned earlier, the Dow is comprised of 30 hand-picked blue chip stocks. The Dow has a committee that decides which 30 stocks belong on the index and they most recently voted to kick out three stocks on September 23rd, 2013. Two of those three stocks have proven to be big winners so far this year while all three of the additions have had negative returns. The committee’s actions contributed to the underperformance.
— Bespoke (@bespokeinvest) June 30, 2014
As technology has allowed advancements in the calculation of indexes, larger and better constructed indexes are more accurate gauges of the market. The Dow is still fun to follow and predictions of Dow XX,000 will continue to rain in, but its days as the best market indicator are well behind it.