News stories about the Dow Jones Industrial Average (the Dow 30) hitting 30,000 are cropping up. I’ve also seen reports that the Dow’s +12% rise in November was the index’s best month since January 1987. Most of the columns I’m reading also suggest stocks are running too hot, or that we can expect resistance at the 30,000 level. Predictions are all over the place.

In my view, this type of financial media reporting is simply following a long-time pattern of fixating on – and assigning importance to – specific price levels for the index. I can remember the extensive coverage and amazement when the Dow finally reached 10,000. But then it was 20,000, and then it was 25,000, and now here we are today. The coverage of these Dow landmarks seems to imply that each round number is a somehow a critical indicator for the future of stocks and the economy.1

I disagree.

I think placing outsized importance on the Dow’s price levels assumes the index is a good proxy for the broad market, and it may also assume the Dow 30 is a strong indicator for the health of the broad economy. But in my view, the index is neither of these things.

First, I do not see the Dow 30 as a good proxy for the broad market. The Dow is made up of only 30 stocks, and there are really no detailed guidelines on why a company is included in the index. A committee of people from S&P Dow Jones Indices and The Wall Street Journal ultimately decide which companies to include, and there is no strict blueprint for doing so. Though the companies included are large-cap, usually iconic U.S. corporations, the list is far too narrow to offer strong insights about the broad markets.

Second, the Dow 30 is a price-weighted index, which in my view is fundamentally flawed. A price-weighted index means that if a stock’s price gets cut in half (think 2-for-1 stock split), then its weight in the index also gets cut in half – even though the company is the same size after the stock split. A company’s stock price alone tells us very little about the company.

A better way to construct an index, in my view, is by making it capitalization-weighted. With a cap-weighted index, bigger companies end up having more weight and influence in the index, which makes good sense to me. As a company grows in size, its importance in the index and the economy also grow in tandem. But this is not how the Dow works.

As for the Dow 30 being a strong indicator for the health of the broad economy, the same argument generally applies. The health of 30 companies is probably not a good representation of how the economy is performing as a whole. I think it makes better sense to look across various, broader, and cap-weighted indices like the S&P 500, the Russell Midcap Index, and the Russell 2000 (small-cap) just to name a few. I think it’s also worthwhile to look across value and growth, and to follow trends across sectors.

The stock market’s rally off the March lows were driven in large part by tech-heavy, growth heavy names. But one of the more interesting trends I’m seeing in the markets today is capital rotation into underperforming areas of the market, such as value, small-caps, banks, and energy. The Russell 2000 index of small-cap names rose +18% in November, clocking its best ever monthly gain, and value was one of the best performing categories last month. These are the stories to keep an eye on – not arbitrary Dow 30 index levels.

Bottom Line for Investors

The Dow Jones is the classic U.S. stock index, with a storied history. But investors would be better served to use the S&P 500 Index as the proxy for large-cap, American corporations – which also tend to provide useful insight about the market and economy as a whole. The S&P 500 includes 500 companies, with defined criteria for being included, and it is capitalization weighted. It checks all the boxes for proper index construction.

So, with the Dow crossing 30,000 or hovering around this level, do not focus too much on what that means for the markets and economy or where we go from here. Remember, it’s just a number.

Disclosure

1Wall Street Journal. November 30, 2020. https://www.wsj.com/articles/global-stock-markets-dow-update-11-30-2020-11606732360?mod=hp_lead_pos3

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