Dow 13,000: What It Means to You

Dow 13,000: What It Means to You
Dow 13,000: What It Means to You

We're back, baby! On Tuesday, the Dow Jones Industrial Average (^DJI) closed at 13,005. This was the first time the Dow had crossed the 13,000 line since its plummet as the nation sank into the financial crisis.

The Dow reached the 13,000 mark for its first time ever on April 25, 2007 -- just a bit less than five years ago. It kept climbing, all the way up to close at 14,164 on Oct. 9, 2007. But then began its long slump, and on May 19, it dropped back below the 13,000 mark, and has stayed sub-13,000 up until this week. (So for anyone thinking there's still room for this rally to grow -- 14,164 is the number you're shooting for. We're not fully "back" for another 1,100 points.)

All this does beg one question: Just what is this thing we call "the Dow" anyway? And when we say that it has hit 13,000... 13,000 whats? Is it 13,000 "points"? Or 13,000 dollars? What's all the fuss about, anyway?

A Brief Primer on the Dow

At its most basic level, the Dow Jones Industrial Average is a figment of The Wall Street Journal's imagination. Originally designed by the editor of the Journal on May 26, 1886, the Dow is an index that tracks the values of 30 of America's biggest companies. Today, it includes the following firms:

* Alcoa
* American Express
* Boeing
* Bank of America
* Caterpillar
* Cisco Systems
* Chevron
* DuPont
* Disney
* General Electric
* Home Depot
* Hewlett-Packard
* Intel
* Johnson & Johnson
* JPMorgan Chase
* Kraft
* Coca-Cola
* McDonald's
* 3M
* Merck
* Microsoft
* Pfizer
* Procter & Gamble
* AT&T
* Travelers
* United Technologies
* Verizon
* Walmart
* ExxonMobil

As you can see, many of these 30 components of the Dow Jones Industrial Average have nothing to do with "industry" at all. American Express does credit cards. JPMorgan does banking. Kraft makes cheese. It wasn't always that way.

Nearly all of the companies named above are household names today, but when it was originally established, the Dow included firms such as American Cotton Oil Co., Distilling & Cattle Feeding Co., and U.S. Leather.

Never heard of them? That's not surprising. New names are added and subtracted from the index all the time as companies are born and die, merge and get acquired, declare bankruptcy, and restructure themselves. Indeed, the Dow components have changed dozens of times over the past century.

Getting to the Points

Any company that's part of the index in a given year has a stock price that's quoted on U.S. stock market exchanges. Add up the prices of the 30 stocks now on the Dow, though, and you'll find that they still fall far short of "13,000." Nor does the "13,000" relate to the market capitalization of the companies, as many people probably think.

In fact, the truth of the matter is that the Dow's value is calculated by a complex mathematical formula. At its simplest level it looks like this:

But in certain instances, such as when a company "splits" its stock or

makes other changes that could mess up the formula, the Dow magicians have to use a formula as complex as this:

Clear as mud, right? OK, so let's make this simple: Basically, every time a stock on the Dow -- Caterpillar, let's say -- goes up in price by $1, the Dow adds 7.57 "points." Every time another stock -- let's stick with the C's and say Chevron -- drops by $1, the Dow loses 7.57 points. Add up all the changes, up and down, that happen to Cat, Chevron, and the other 28 stocks on the Dow on a given day, and multiply by 7.57, and this gives you the change in value of the index for the day.

This also means that just five companies with high share prices -- Caterpillar, Chevron, Exxon, IBM, and McDonald's -- out of the thousands of stocks listed on U.S. exchanges, make up nearly 4,600 of the Dow's points.

I Can See Clearly Now...

The Dow's climb back to 13,000 made a lot of headlines this week. Even with official unemployment at 8.3%, and many, many more people than that underemployed or too discouraged to seek a job anymore, the Dow's rise has a lot of people thinking that our economy has nearly recovered.

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Don't believe it. Even if you can't follow the math of the equations up above, their complexity should make one thing clear: The Dow doesn't mean what many people seem to think it means. The stock prices of a handful of companies should not be taken as a true proxy for the American economy.

We may be back to "13,000," but we're not truly "back" just yet.

Motley Fool contributor Rich Smith does not own shares of any company mentioned above. The Motley Fool owns shares of JPMorgan Chase, Johnson & Johnson, Walmart, Microsoft, Coca-Cola, Bank of America, International Business Machines, Cisco Systems, and Intel. Motley Fool newsletter services have recommended buying shares of Coca-Cola, Microsoft, Johnson & Johnson, Pfizer, 3M, Walmart, ExxonMobil, Procter & Gamble, McDonald's, Chevron, Walt Disney, The Home Depot, and Intel. Motley Fool newsletter services have recommended creating a written covered strangle position in American Express. Motley Fool newsletter services have recommended creating a bull call spread position in Microsoft and creating diagonal call positions in Johnson & Johnson, Walmart and 3M.