Can we improve the Dow?

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There has long been criticism about how the Dow is calculated. While most indices are weighted by market capitalization, the Dow is weighted by price. This can skew things significantly (you can read more about that in Zac Bissonnette's post on the subject).

There has also been much criticism of late that the Dow Jones Industrial Average index no longer provides an accurate snapshot of the overall U.S. economy.

But if not the Dow, then what? What would be a better approximator? Well, many would be content to look at the broader index, the S&P 500, but if we just wanted to keep it to 30 companies, the number of components currently in the Dow, one could use the top 30 companies in the S&P 500. Better yet, one can use the 30 companies with the highest market capitalization. Surely, there's a reason their market cap is high.

Calculating these 30 companies at Friday's close gives a simple average of 41.08, compared to the Dow's 30 companies simple average price of 30.83 -- that's 33% higher. If we apply the Dow's divisor instead of the simple average we get the Dow's close on Friday (30.83*30/0.125552709) of 7365.67. Applying the same divisor to the 30 companies with the highest market cap (which isn't right really, but for comparison purposes only) we get 9815.72. Wouldn't you like to have the Dow there now?

(One point to make is that Google and Berkshire Hathaway are not included so that they wouldn't affect the results too much.)

But do the highest market cap stocks really represent the economy better? Not necessarily.

Looking at fourth quarter GDP, we can find the weight of the different sectors. It's quite clear from the GDP that the Dow does not reflect the economy, nor do the top market capitalized stocks. For one thing, where are the housing companies? For another, even if we put Ford in the index, the car companies stocks wouldn't amount to their real weight in the economy.

The guardians of the Dow, The Wall Street Journal editors, try to keep to a minimum any changes in the component stocks. Striving then to keep as much of the original Dow as possible, I've replaced only five stocks. GM (GM) stayed, despite Ford (F) having a slighly higher market cap. Similarly, Intel (INTC) and Hewlett-Pakcard (HPQ) could have been replaced with the larger Cisco (CSCO) and Apple (AAPL), but weren't. Bank of America (BAC), Citigroup (C) and American Express (AXP), however got the boot, and Wells Fargo (WFC) took their place. Similarly, Alcoa (AA) was replaced with Freeport McMoran (FCX). Toll Brothers (TOL) and D.R. Horton (DHI), despite their small market cap, were added to better represent housing and construction and UPS (UPS) was added for transportation. Chevron (CVX) also got the boot since oil & gas was overweighted.

After all these changes, the simple price average was 30.82 compared to the original 31.36 -- a small change. With the divisor it was 7494.06, compared to 7365.67.

Perhaps the Dow needs changing to reflect the economy better, but it seems that this won't necessarily change things much. Investors, traders, may want to blame their losses on the index, but the fact is that the only thing that is to blame is the economy (and the plethora of reasons we're in recession today).

DJIATop 30 market capEconomy weighted
AAAAPLBA
AXPABTCAT
BAAMGNDD
BACCOPDHI
CCSCODIS
CATCVXFCX
CVXDNAGE
DDGEGM
DISHPQHD
GEIBMHPQ
GMINTCIBM
HDJNJINTC
HPQJPMJNJ
IBMKOJPM
INTCMCDKFT
JNJMRKKO
JPMMSFTMCD
KFTORCLMMM
KOPEPMRK
MCDPFEMSFT
MMMPGPFE
MRKPMPG
MSFTQCOMT
PFESLBTOL
PGTUPS
TVZUTX
UTXWFCVZ
VZWMTWFC
WMTWYEWMT
XOMXOMXOM
30.8341.0831.36
7365.679815.727494.06
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