About a week ago I mocked the notion that everything was hunky-dory because the Dow was at an all-time high. But I hate to admit that I had no idea just how meaningless that statistic was. For one thing, the Dow wasn’t actually at an all-time high.
And it gets worse from there. The Dow, which we all know as a stodgy and unrepresentative sample of 30 large American companies, is even sillier than I realized. I learned just how silly last night listening to this highly recommended Planet Money podcast from the right-wing hacks at NPR.
Let’s start with the (lack of) a new record. A couple of commenters, Dustin and SPQR, noted the issue: the Dow number doesn’t adjust for inflation. As Adam Davidson of Planet Money notes, this is completely absurd, because basically every economic statistic adjusts for inflation. The fact that the Dow does not is only one example of how silly it is. Adjusted for inflation, the Dow’s actual historic high happened in 2000. (And then . . .)
But it gets worse, because the Dow is an absurd measure of stocks anyway. Place to one side the fact that it’s only 30 stocks. (You’re far better off with something like the S&P 500 or the Wilshire 5000.) The other, even more significant problem, is the way that stocks within the Dow are weighted. Basically, they aren’t. This ridiculous measure simply adds up the stock prices (and then divides them by some proprietary divisor, which makes no real difference). What this means is that companies whose individual shares represent a greater percentage of their market cap have larger effects on the total number, which makes no sense.
IBM swings the Dow to and for out of proportion to its size, just because each of its stock shares is a higher percentage of its market cap.
The example Planet Money uses is this. Let’s say AT&T and IBM each have a market cap of $100. But AT&T has 100 shares and IBM has two. AT&T shares are worth a dollar; IBM shares are worth $50. If AT&T goes down 10% and IBM goes up 10%, the market is neutral. But each AT&T share goes down a dime. IBM goes up $5. So the Dow shows a considerable increase even though nothing has really happened.
Which is totally absurd.
So why is it this way? They talked to an expert, and apparently the answer is: the Dow was devised before computers, and they just made it really simple (read: inaccurate). In other words, it sucks because it’s old.
So why not change it? Because the Dow is considered valuable because it’s old. Seriously: that’s about the only thing it has going for it. If you change it, it loses its only unique feature: its age.
The best part is that Adam Davidson thinks people in the media, at least people who understand financial matters, know all this. Yet they still report on the Dow as if it means something. It doesn’t.
Even if it did, of course, the stock market is not an indication of how the economy is doing. But it’s very important to understand that the Dow is really a meaningless number that no sophisticated person pays attention to (except, perhaps, to gauge what direction the herd might be going).
UPDATE: That last parenthetical was added in response to a point made by a commenter.