How the Dow Hides the Bear

Its methodology paints too rosy a picture

If you're comforted that the Dow Jones industrial average didn't drop 20% to signify a bear market, think again. You're looking at an illusion created by the way the Dow is calculated. In truth, the market value of Dow companies fell nearly 29% from its high on Jan. 14, 2000, through its recent low on Mar. 22, not the 19% you probably read about. The value lost was about the same as the 28% decline in the Standard & Poor's 500-stock index, compiled by a unit of The McGraw-Hill Companies, which owns BusinessWeek.

Why the discrepancy between the reported average and the actual change in value? Do the math: The Dow is an average of share prices rather than an index weighted by market capitalization, such as the S&P 500, the Nasdaq Composite Index, and even the modern indexes Dow Jones & Co. has created for markets around the world. Market-cap indexes are based on the market value of companies' outstanding shares. The Dow's level is simply an arithmetic average of the dollar prices of one share of each of its 30 member stocks.

SKEWED. When viewed from the perspective of market cap, the picture of the recent Dow is as ugly as the bear that mangled the S&P 500. Of the 30 Dow stocks, 21 lost market value through Apr. 9. Of the nine that are worth more, three gained because of mergers and takeovers rather than share appreciation. For example, Alcoa's (AA ) market cap would have sunk if not for a 17% increase in the number of its shares to make a number of acquisitions, including Reynolds Metals Co. In some cases, such as AT&T (T ) and International Paper Co. (IP ), not even the issuance of more shares made up for the stock-price decline.

The Dow's picture of the market is no prettier if you look closely at the prices of its member stocks. Through Apr. 9, just six issues--Boeing (BA ), Merck (MRK ), 3M (MMM ), Philip Morris (MO ), SBC (SBC ), and United Technologies (UTX )--have risen since the January, 2000, high. Among the losers, no category was spared, not even Old Economy companies. Procter & Gamble Co.'s (PG ) shares tumbled from $117 to $60.34 as the personal-care products maker warned of a squeeze on profit margins. The three financials in the average all declined, as did the sole oil stock, Exxon Mobil Corp. (XOM ) In fact, the only big winners were Boeing and Philip Morris, whose share prices doubled. And four big tech stocks--Hewlett-Packard (HWP ), Intel (INTC ), IBM (IBM ), and Microsoft (MSFT )--together contributed about 1,240 points to the Dow's 1,900-point decline.

Dow Jones doesn't lose too much sleep over these oddities. John A. Prestbo, editor of the Dow Jones Indexes, says that every now and then the Dow average and its underlying market value get out of line. "Over the long run, the methodology is not significant," he says. "The point is to tell you the trend."

When Charles H. Dow first published his average on May 26, 1896, he added up the prices of 12 stocks and divided by 12 to get the measure of the market. Today, the methodology is the same except that the divisor has changed over the years to keep the average from jerking around with every takeover, bankruptcy, and stock split. Now, it's 0.15369402, and a $1 change in any stock causes a 6 1/2-point change in the average.

"NOBODY CARED." But by treating each dollar rise or fall the same way, the Dow obscures the importance of market value. For example, if Intel Corp., whose market cap represents about 5% of the Dow's total value, were to declare bankruptcy and its stock were to fall to zero, the effect would be a 151-point decline--only a 1 1/2% slip in the average. So why didn't Charles Dow index the companies to market value? At the time, there was only a simple understanding of indexes, says Yale University economist Robert J. Shiller, the author of Irrational Exuberance: "Nobody cared about market caps."

Today, market caps are of greater importance to institutional money managers who care little about the discrepancy in the Dow, says Laszlo Birinyi, a global trading strategist at Deutsche Bank. Indeed, few institutions use the Dow as part of their trading strategies anymore.

For all its shortcomings, the Dow remains an important measure to individual investors. It's included in TV and newspaper coverage and influences how investors feel about the market. It's also the best-known market barometer. But until the Dow gets back in sync with broader measures, investors in its 30 stocks may be suffering bigger losses in their portfolios than they see in the average.

By Robert J. Rosenberg in New York

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