Market Minute - January 13, 2017

Market Minute Final Blog.pngby Scott Rosenquist, CFA
Dow 20,000

The Dow Jones Industrial Average (Dow) is one of the oldest stock market indices in the world dating back to the late 1800’s.  The index contains 30 stocks of companies from the United States with most of them well known.  The Dow has been approaching the level of 20,000 since late last year, a level it has never reached.  It came within a point of that mark just recently.  Since the Dow contains only 30 stocks it does not provide the best measure of the broad market.  Most institutional investors refer to the Standard & Poor’s 500 when assessing the market. 

The main difference between the Dow and other stock market indices is how it weighs each stock in the index.  The Dow is price weighted meaning it weighs the stocks in the index by the price of the stock.  For example, Goldman Sachs currently has the largest weight in the index since it’s trading for over $200 per share.  Compare that to Microsoft that is trading around $60 a share but is a larger company.   The S&P 500 on the other hand is market value weighted.  Market value, also referred to as market capitalization (cap), is the total number of shares outstanding for a company multiplied by the current price of the stock.  The companies with the highest market cap receive the largest weight in the S&P.  Currently, Apple is the largest company in the S&P with a market cap over $600 billion.  Walt Disney has a market cap around $170 billion.  Apple clearly is a larger company and therefore carries more weight in the index.

You can see how these two indices are constructed differently causing them both to have biases. The Dow favors companies trading at a higher price per share without respect to the size of the company.  The S&P favors larger companies and puts less weight on companies with a smaller market cap.  While we watch as the Dow attempts to reach 20,000, it is important to recognize it is not the best indicator of the overall market direction.  It is too narrow of an index that can be heavily influenced by the moves of just a few stocks.  The S&P includes all of the stocks in the Dow and many more making it a better representation of the overall market.  Investors tend to favor products that track the S&P compared to the Dow due to the broader construction of the index.

 

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