The Dow Jones Industrial Average has been around since 1896, and it’s still the index most Americans use as their primary gauge of stock market performance. But that doesn’t mean the Dow Jones is useful from the standpoint of technical analysis.
In fact, two key aspects of the Dow Jones prevent its chart from generating any truly meaningful signals.
Nevertheless, the fact that the Dow chart has made a triple-top on an inflation-adjusted basis has made news this week. And sure, looking at inflation-adjusted index performance certainly has its merits. For one, it provides a sense of the true purchasing power stemming from investment gains over the years. And from this standpoint, the Dow Jones is now sitting at the same level where it hit highs in 2000 and 2007 — just prior to this decade’s two market meltdowns.
But while there are any number of reasons why the market may be vulnerable to a selloff in the months ahead, this isn’t necessarily one of them.
In fact, the Dow Jones, by virtue of its ever-changing components and unique method of construction, is the least-effective indicator of the major indices.
Dow Jones’ Changing Composition Muddies the Waters
It’s no secret that all indices change their holdings over time. The Nasdaq of today is quite different from the Nasdaq of 2000, reflecting the evolving landscape of corporate America. However, the Dow Jones Industrial Average only has 30 components — meaning that each change has a substantial impact on the roster of companies held in the index.
Barry Ritholtz published this interactive chart of Dow Jones components dating back to 1884, which shows what the index held in each year. While interesting in its own right, it reveals something important about the index: The 2013 DJIA includes ten companies that weren’t even in the index during the first leg of the triple top back in 2000:
Home Depot (HD)
Cisco Systems (CSCO)
Goldman Sachs (GS)
United Health Group (UNH)
That means one-third of the index has changed in this decade alone. While all indices experience turnover, the extent of the Dow’s transformation makes it difficult to draw meaningful apples-to-apples comparisons over a multiyear period.
As for the other reason…
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|
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.