Another View: It’s Time to Rebuild the Dow

The New York Times, April 23, 2009

The need to overhaul the Dow Jones industrial average has become even greater since the financial crisis hit, says Jonathan F. Foster, founder and managing director of the private equity firm Current Capital.

The remarkably troubled economy and capital markets are causing pain in many ways. For example, unemployment is now at about 8.5 percent, with some 6 million Americans claiming unemployment benefits, a situation not seen in 25 years.

In addition, the nation’s equity and debt markets are both moribund: There were just two initial public offerings of stock raising more than $100 million in the first quarter of this year, and the debt markets are just beginning to show some improvement in tone thanks to extraordinary government efforts.

Amid the variety of macro efforts to bring liquidity and confidence back into the markets that have garnered front-page headlines and monopolized the Sunday morning talk shows, it is easy to forget that many granular benchmarks and tools are in urgent need of revision in order to provide the thoughtful information required for good decision-making.

One important example is the Dow Jones industrial average, known as the DJIA or the Dow 30.

Created in 1896, the DJIA is computed from 30 of the largest, most widely held and prominent public companies in the United States. Originally a group of industrial companies, the DJIA now includes companies in a variety of sectors. It is the best known and most often cited stock market index. In fact, it has become, in many ways, a proxy for “how the market traded” over a given period.

A number of steps are taken to try to make the Dow 30 as appropriate as possible. For instance, it is a scaled, not actual, average: the sum of the component prices is divided by a divisor to adjust for stock splits and other similar transactions. In addition, the DJIA is price weighted. While some have criticized the Dow 30 for quite a while for being a price-weighted average, this has now become a major problem.

Because the DJIA is a price-weighted average, a $1 increase or decrease in a lower-priced stock is as important to the index as a $1 increase or decrease in a much higher-priced stock, even though the first stock experienced a larger percentage change. Moreover, this calculation does not consider the relative sizes or market values of the 30 companies in the index.

It is easy to forget how far and how fast the values of some of the largest, most important corporations in America have fallen. For example, General Motors now trades at less than $2 a share, having sold at over $24 a share within the last year. Citigroup has had a remarkably similar decline: it is valued at approximately $3 per share, far from its 52-week high of over $27.

In September of last year, the ballooning financial crisis became evident when Lehman Brothers filed for Chapter 11 bankruptcy protection and the DJIA lost more than 500 points in one day for only the sixth time in history. Remarkable volatility continued over the next few months, with the DJIA having its largest one-day point loss, largest intraday range and largest daily point gain.

In fact, this drastic volatility has continued. Consider that:

  • Fourteen of the largest 20 daily point gains have occurred in 2008 and 2009.
  • Thirteen of the largest 20 daily point losses have occurred in 2008 and 2009.
  • The largest 20 daily percentage gains took place in the Great Depression, except for one in 1987 and three in 2008 and 2009.
  • The largest 20 daily percentage losses took place in the Great Depression, except for four in 2008 and 2009.
  • All but four of the largest intraday point swings since 1987 have taken place in 2008 and 2009.

Of the original 12 DJIA companies, just General Electric remains. Yet even its stock price adds chaos to the Dow 30 today. This bellwether of American industry has a stock price of some $12, well below its 52-week high of about $37 (yet above its low over the period of about $6).

An urgent revision of the DJIA is necessary. While many academics have said for years that the stock market is “efficient,” or reflecting all available information, good information is required to make good decisions. Clearly, a 50-cent change in a $2 stock, even if it is a major name in United States industry or one of the world’s most recognized financial institutions, should not have as large an impact on a critical stock market index as a 50-cent change in, say, a $54 stock, McDonald’s.

The specifics on how to fix the DJIA should be left to statisticians. However, the concept is clear: the Dow 30 should be a market-weighted average revised periodically that reflects the major sectors of the economy in rough proportion to each industry’s percentage of the overall United States economy.

While the remarkable disruption in our economy and markets have led to drastic efforts by governments, regulators and other constituencies to avoid even more pain, we should not lose sight of the need to adjust important benchmarks and indices, like the DJIA, in order to provide quality inputs that facilitate quality decisions.