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Don’t Kill Yourself Interpreting Dow Jones’ Charts

The Dow is a poor technical indicator for two very simple reasons

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Price-Weighting Changes Everything

The second issue is that the Dow Jones is built using a different methodology than other indices. The Dow is built using a price-weighted system that affords the greatest performance influence to the highest-priced stocks. The importance of this effect can be seen by looking at the comparative weightings of the top three and bottom three holdings in the SPDR Dow Jones Industrial Average ETF (DIA).

Rank STOCK Ticker 12/10 Price Index Weighting
1 Visa V $199.43 8.0%
2 IBM IBM $177.12 7.1%
3 Goldman Sachs GS $169.13 6.8%
28 General Electric GE $27.14 1.1%
29 Intel INTC $24.82 1.0%
30 Cisco Systems CSCO $21.21 0.9%

Over the years, this approach to index construction has kept the Dow from varying too far from other indices. In fact, DIA’s 7.28% 10-year average annualized total return is nearly identical with the 7.43% return generated by the SPDR S&P 500 ETF (SPY). And part of that small difference is a result of DIA’s slightly higher expense ratio.

Instead, the Dow methodology means you should avoid splitting hairs when it comes to the index’s long-term technical picture. A simple decision by a company to split its shares — or not to split, in the case of Visa — would put the index at a different price and thus paint an entirely different technical picture for the index. Put another way, if Visa had split its shares three years ago, the Dow Jones wouldn’t be as close to its previous inflation-adjusted highs, and there would be no need for a discussion about a possible inflation-adjusted triple top.

The Bottom Line

The concept of a Dow triple-top makes for an interesting news item, but be careful about reading too much into it. The Dow’s idiosyncratic nature should cast doubt on its long-term technical signals, and traders need to weight them accordingly.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, http://investorplace.com/2013/12/dow-jones-pitfalls-technical-analysis/.

©2014 InvestorPlace Media, LLC

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