The Dow Jones Industrial Average has been on a bullish tear (climbing above 23,000) since early September (when it was below 22,000), and it doesn’t show any signs of slowing down.
Is this meteoric rise sustainable? Yes it is.
Let’s break the Dow down into its component parts to see why.
How Is the Dow Calculated?
First, the Dow is a highly concentrated stock index. With only 30 component stocks, the Dow does its best to track the market at large — and it typically does a pretty good job — but because it doesn’t cover 500 stocks like the S&P 500 does, it leaves itself open to a few stocks exerting an outsized influence on the index.
Second, unlike the S&P 500, which is a market-cap-weighted index, the Dow is a price-weighted index. This means that instead of the index being driven primarily by the largest companies (those with the largest market capitalization) within the index, it is driven by the highest-priced stocks.
While setting up a price-weighted index was a good way to track corporate strength more than 100 years ago when the Dow was first created, the subsequent market-wide adoption of practices like stock splits has introduced some weaknesses into this methodology.
To illustrate the impact these methodological choices — only having 30 stocks in the index and calculating the index based on stock price rather than market-cap — let’s take a look at International Business Machines Corp. (NYSE:IBM).
If you were to rank the 30 components of the Dow according to market-cap, IBM would be No. 22. However, if you rank the 30 components according to share price, IBM is No. 8, which gives the stock an outsized influence on the index.
Table 1 — Components of the Dow Jones Industrial Average
To put this in perspective, IBM — with its $150 billion market-cap — can move the Dow almost as much as Apple Inc. (NASDAQ:AAPL) — with its $802 billion market-cap.
That’s exactly what happened today. IBM released its quarterly earnings last night and surprised investors by revising its full-year outlook higher. This apparently pleased investors because they sent the stock soaring more than 9% higher in trading Wednesday (see Fig. 1).
Fig. 1 — Daily Chart of International Business Machines (IBM)
This surge in IBM’s share price, in turn, sent the Dow soaring higher as well, even though many of the larger stocks in the index didn’t move very much that day (see Fig. 2).
Fig. 2 — Daily Chart of the Dow Jones Industrial Average (DJIA)
One stock, if its share price is high enough, really can drive the Dow.
The Bottom Line
Take a look at the highest-priced stocks in the Dow. They are all in bullish uptrends that have taken them to, or close to, new all-time highs.
We anticipate that these bullish trends are going to continue as investors move more of their money into the relative safety of large-cap stocks with strong momentum.
If we’re right, and earnings season continues to provide bullish surprises, 23,000 may soon fade into the distance as the Dow climbs higher.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.
Most recently, John and Wade are co-options strategists of Turbo Trader Live — a live, interactive trading room service that runs two hours every trading day the market is open. Turbo Trader Live focuses on long call and put options, as well as long and short vertical spread strategies. Find out how to get in on the live trading action and start making real profits by clicking here.
