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Business Unusual

How the Dow Jones Industrial Index tracks the state of the US stock market

2 September 2020 7:47 PM

Almost a century after it began the last original stock is removed from the index

In 1928, the Dow Jones Index was expanded to list 30 stocks, 92 years later there are still 30 stocks that make up the index, but on 1 September 2020 the last original stock, ExxonMobil was removed. This is the story of how the index came about, how it helped investors better understand the market and if it still can.

In the beginning

While the ability to buy shares in ventures and companies has been around since the Dutch created the first company to bankroll their colonial exploration, the ability to determine what a fair price was and if it was likely to grow or decline was much harder. It is still not an exact science but the predominant method was to determine how much of a product or service could be produced, how much of that could be sold and what margin of profit might be earned as a result. It is still an important part of assessing a company and is called fundamental analysis.

It was not the only way to determine if a company would do well, shares can be valued based on market sentiment. In this way a company that may not have built a new railway, but had a railway that passed nearby a new oil field would create the potential for more freight to be using the line in the near future. You did not need to wait for the company to actually show the profit you could assume it would follow and better yet you could assume when others heard about it they would want to buy shares too.

But it was hard to know what was happening before 1900 and the information you did get could have been false.

Three men set out to create a way to assess the performance of a group of shares to not only provide an insight into what was happening with those companies, but because the companies were chosen to represent the entire market a positive increase in the index would suggest an overall positive move in the entire market. Two of those men were Charles Dow and Edward Jones which is how the Dow Jones Industrial Index came to be named.

The initial daily newsletter proved popular enough that the men went on to found the Wall Street Journal.

They used a method to determine the underlying value of a company based on factors relating to its share price that has become known as technical analysis. When most of the indicators about the share price for the stocks on the index are positive they are likely to rise and when they are negative you can expect them to decline. They coined the terms bull markets when it was rising and bear markets when it drops.

In 1928 the index was expanded to include 30 shares and one of those was ExxonMobil or as it was known then Standard Oil.

The current list reflects a group of companies that are mostly not industrial stocks but rather financial, technological, pharmaceutical and retail stocks, however these days they occupy the same place in society that industrial stocks did a century ago.

The Dow Jones now

If you were to ask a 100 people to name a stock index, many if not most would mention the Dow Jones even if they did not know what it actually means. A higher index is better than a lower one and a slowly increasing or decreasing trend is better than one that moves dramatically.

A high priced share has more weight than a lower priced one, although they tend to move less as a percentage than lower priced stocks.

You might assume than in a year that has the worst pandemic for the last century which has created a global recession and huge unemployment that the index would be at some of the lowest levels of the last few decades and certainly nowhere near the highest levels. It reached a new high in February 2020 and then fell by 10 000 points by the end of March, the index has increased since then almost reaching record levels again at over 28 000 points.

One reason is that the 30 companies are some of the most successful global businesses and that while every country has been badly affected, the richest consumers in the world are able to sustain a lot of the performance of those companies because the index does not measure the output, sales and profit as much as the perception that the share price of these companies will rise.

Apple broke records just two years ago by having its shares exceed $1 trillion in market value. In 2020 it is worth over $2 trillion. It was not a new Apple product or service that prompted the increase; it was the belief that the demand for Apple shares will continue to rise. As a way to keep that momentum, Apple split its shares turning one share into four. It makes it cheaper to buy an Apple share and there are now more shares that could be placed into the market. Share availability is a key part of the shift to modern trading, more about that later.

In a recession, typically governments and banks want to ensure there is money to keep the economy moving. You might assume that the money would be used to make things or start new business, but you could also take the money and just buy shares. If the shares go up in value you get richer even though nothing is actually added in the real economy.

This is partially how the index can continue to climb even though there is no fundamental reason it should.

Trades for the sake of trading

This brings us to how most trading happens now. Rather than a few trades taking place a day and investors holding a position to get returns on dividends, the market increased in volume and speed.

If I make only a small profit on a share but can afford to buy many shares and only for a short time to have the share edge up or down I would be able to make a tidy profit by making many trades.

Humans can’t work that fast, but machines can and so most trades now are simply machines buying and selling shares with other machines that are given instructions about the conditions to decide if they should sell or buy.

It is very difficult to set up an effective system and you will need a big pool of money to make it work well. For small traders and certainly individual traders you can’t compete with the algorithmic trades. So the big companies make the money and the rest of us have to give our money to add to their growing pools. The profits don’t come from companies performing better or making better products. The profits come from big players taking profits from other investors and pushing small investors out the market.

That may sound odd as there are many more options for people to get access to buy shares now, but it appears those platforms offer low cost or free trades that are actually added to the high volume traders pools to see if they can make those trades at a better rate than the person agreed to pay. There is a lot more to how this works but it is beyond the scope of this article.

The point is that with so much else determining if a share will go up or down, then an index that consists of only 30 shares that does not take all the additional factors that come into play with high volume trading then the index is less useful for actually reflecting the state of the economy or even the state of the stock market.

Things don’t last over a century and then just die out so we can expect that while this index may be likely to become less prominent, it is fair to say that the thing that moves the market is information and as the market gets faster and generates more information, we can expect updated indicators and if buying a share is getting hard, why not simply buy the entire index.

2 September 2020 7:47 PM

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