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Every time the number of, or specific constituent, companies change in the Dow index any comparison of the
new index value with the old index value is impossible to make with any validity whatsoever. It is like comparing the taste of a cocktail of fruits when the number of different fruits and their distinctive flavours – keep changing. Furthermore, because of the application of the ever changing Dow Divisor, we are always comparing a basket of today’s apples with a basket of yesterday’s pears.
So says Wim Grommen in edited excerpts from his original article entitled The DJIA Is A Hoax.
[The following is presented by Lorimer Wilson, editor of www.munKNEE.com and may have been edited ([ ]), abridged (…) and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. This paragraph must be included in any article re-posting to avoid copyright infringement.]
Grommen goes on to say in further edited excerpts:
1. Value Manipulation – The Dow Divisor
- The Dow was first published in 1896 when it consisted of just 12 constituents and was a simple price average index in which the sum total value of the shares of the 12 constituents were simply divided by 12. As such those shares with the highest prices had the greatest influence on the movements of the index as a whole.
- The Dow 12 became the Dow 20 in 1916 when four companies were removed from the original twelve and twelve new companies being added.
- The Dow 20 became the Dow 30 in October, 1928 but, more importantly, the calculation of the index was changed. Instead of the index being a simple price average index in which the sum total value of the shares of the constituents were simply divided by the number of constituents, the sum of the value of the shares of the constituents began to be divided by what is known as the Dow Divisor.
- On October 1st, 1928, when the Dow was enlarged to 30 constituents, the calculation formula for the index was changed to take into account the fact that the shares of companies in the Index split on occasion. It was determined that, to allow the value of the Index to remain constant, the sum total of the share values of the 30 constituent companies would be divided by 16.67 ( called the Dow Divisor) as opposed to the previous 30.
- On October 1st, 1928 the sum value of the shares of the 30 constituents of the Dow 30 was $3,984 which was then divided by 16.67 rather than 30 thereby generating an index value of 239 (3984 divided by 16.67) instead of 132.8 (3984 divided by 30) representing an increase of 80% overnight!! This action had the affect of putting dramatically more importance on the absolute dollar changes of those shares with the greatest price changes – but it didn’t stop there!
- On September, 1929 the Dow divisor was adjusted yet again. This time it was reduced even further down to 10.47 as a way of better accounting for the change in the deletion and addition of constituents back in October, 1928 which, in effect, increased the October 1st, 1928 index value to 380.5 from the original 132.8 for a paper increase of 186.5%!!! From September, 1929 onwards (at least for a while) this “adjustment” had the affect – and I repeat myself – of putting even that much more importance on the absolute dollar changes of those shares with the greatest changes.
From the above analyses/explanation it is evident that the dramatic “adjustments” to the Dow Divisor (coupled with the addition/deletion of constituent companies according to which transition phase they were in – see below) were major contributors to the dramatic increase in the Dow from 1920 until October 1929 and the following dramatic decrease in the Dow 30 from then until 1932 notwithstanding the economic conditions of the time as well. Indeed, one might accurately say that the Dow Divisor contributed to the Crash of ’29!
An index is calculated on the basis of a set of shares. Every index has its own formula and the formula results in the number of points of the index. However, this set of shares changes regularly. For a new period the value is based on a different set of shares. It is very strange that these different sets of shares are represented as the same unit. In less than 10 years, 12 of the 30 companies (i.e. 40%) in the Dow Jones were replaced. Over a period of 16 years, 20 companies were replaced, a figure of 67%. This meant that over a very short period we were left comparing a basket of today’s apples with a basket of yesterday’s pears.
Changes in the Dow, stock splits and the value of the Dow Divisor after the market crash of ‘29
|
Period |
Basket changes |
Stock splits |
Dow Divisor end period |
|
1930-1940 |
18 |
0 |
15,100 |
|
1940-1950 |
0 |
12 |
9,060 |
|
1950-1960 |
5 |
27 |
3,824 |
|
1960-1970 |
0 |
26 |
1,894 |
|
1970-1980 |
3 |
12 |
1,465 |
|
1980-1990 |
5 |
32 |
0,586 |
|
1990-2000 |
11 |
40 |
0,201 |
|
2000-2010 |
7 |
13 |
0,132 |
Even more disturbing is the fact that with every change in the set of shares used to calculate the number of points, the formula also changes. This is done because the index, which is the result of two different sets of shares at the moment the set is changed, must be the same for both sets at that point in time. The index graphs must be continuous lines.
For example, the Dow Jones is calculated by adding the shares and dividing the result by a number and, because of changes in the set of shares and the splitting of shares, the divider changes continuously. At the moment the divider is 0.15571590501117 but in 1985 this number was higher than 1. An index point in two periods of time is therefore calculated in different ways:
Dow 1985 = (x1 + x2 +..+x30) / 1
Dow 2014 = (x1 + x2 +.. + x30) / 0.15571590501117
In the 1990s many shares were split. To make sure the result of the calculation remained the same both the number of shares and the divider changed. An increase in share value of 1 dollar of the set of shares in 2014 results is 6.4 times more points than in 1985. The fact that in the 1990s many shares were split is probably the cause of the exponential growth of the Dow Jones index. At the moment the Dow is at 16,437 points. If we used the 1985 formula it would be at 2,559 points.
2. Constituent Manipulation
Every company goes through a production phase (product life cycle) consisting of a pre-development phase of a dynamic balance in which the present status does not visibly change followed by:
- a take-off phase in which the process of change starts because of changes in the system;
- an acceleration phase in which visible structural changes take place through an accumulation of socio cultural, economic, ecological and institutional changes influencing each other;
- a stabilization phase in which the speed of sociological change slows down and a new dynamic balance is achieved through learning and, finally,
- a degeneration phase in which cost rises because of over capacity and the producer will finally withdraw from the market.
When companies in the take-off or acceleration phase are added to the index, often replacing companies in the stabilization or degeneration phase, this greatly increases the chances that the index will always continue to advance rather than decline. This is obvious, especially when this is done during the acceleration phase of a transition.
For example, from 1980 onward, 7 ICT companies (3M, AT&T, Cisco, HP, IBM, Intel, Microsoft), the engines of the latest revolution and 5 financial institutions, which always play an important role in every transition, were added to the Dow Jones. (see Addendum below for ALL the changes made to the Dow Index since 1997.)
Given the above explanation it is evident that my contention that every time the number of, or specific constituent, companies change in the Dow index any comparison of the new index value with the old index value is impossible to make with any validity whatsoever.
The Real Truth vs. Fictional Truth
Is the number of points that the Dow Jones now gives us a truth or a fictional truth? If a fictional truth then the number of points now says absolutely nothing about the state that the economy or society is in when compared to the past. In that case a better guide would be to look at the number of people in society that use food stamps today – that is the real truth!
Addendum:
Overview from 1997: 20 winners in – 20 losers out, a figure of 67%
September 23, 2013:
Hewlett – Packard Co., Bank of America Inc. and Alcoa Inc. will replaced by Goldman Sachs Group Inc., Nike Inc. and Visa Inc.
Alcoa has dropped from $40 in 2007 to $8.08. Hewlett- Packard Co. has dropped from $50 in 2010 to $22.36.
Bank of America has dropped from $50 in 2007 to $14.48.
But Goldman Sachs Group Inc., Nike Inc. and Visa Inc. have risen 25%, 27% and 18% respectively in 2013.
September 20, 2012:
UnitedHealth Group Inc. (UNH) replaces Kraft Foods Inc. Kraft Foods Inc. was split into two companies and was therefore deemed less representative so no longer suitable for the Dow. The share value of UnitedHealth Group Inc. had risen for two years before inclusion in the Dow by 53%.
June 8, 2009:
Cisco and Travelers replaced Citigroup and General Motors. Citigroup and General Motors have received billions of dollars of U.S. government money to survive and were not representative of the Do.
September 22, 2008:
Kraft Foods Inc. replaced American International Group. American International Group was replaced after the decision of the government to take a 79.9% stake in the insurance giant. AIG was narrowly saved from destruction by an emergency loan from the Fed.
February 19, 2008:
Bank of America Corp. and Chevron Corp. replaced Altria Group Inc. and Honeywell International. Altria was split into two companies and was deemed no longer suitable for the Dow. Honeywell was removed from the Dow because the role of industrial companies in the U.S. stock market in the recent years had declined and Honeywell had the smallest sales and profits among the participants in the Dow.
April 8, 2004:
Verizon Communications Inc., American International Group Inc. and Pfizer Inc. replace AT & T Corp., Eastman Kodak Co. and International Paper. AIG shares had increased over 387% in the previous decade and Pfizer had an increase of more than 675& behind it. Shares of AT & T and Kodak, on the other hand, had decreases of more than 40% in the past decade and were therefore removed from the Dow.
November 1, 1999:
Microsoft Corporation, Intel Corporation, SBC Communications and Home Depot Incorporated replaced Chevron Corporation, Goodyear Tire & Rubber Company, Union Carbide Corporation and Sears Roebuck.
March 17, 1997:
Travelers Group, Hewlett-Packard Company, Johnson & Johnson and Wal-Mart Stores Incorporated replaced Westinghouse Electric Corporation, Texaco Incorporated, Bethlehem Steel Corporation and Woolworth Corporation.
[Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.]
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