The DJIA Versus the S&P 500 Who Wins Research Paper

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Dow Jones Industrial Average (DJIA) has been the most important source available concerning the direction and status of capital markets in the United States for more than a century (Hora & Jalbert, 2009). The DJIA is comprised of the leading publicly traded equity issues which are reported in virtually all major newspapers and news reports in the U.S. as well as other industrialized nations (Hora & Jalbert, 2009). Despite this preeminent position in the financial industry, there remains a lack of understanding on the part of many consumers concerning how the DJIA is calculated or what the results of these calculations actually mean. To help fill this gap, this paper reviews the relevant literature to provide an overview and history of the DJIA and how it is calculated and its constituent components. Finally, a critical evaluation of the DJIA compared to other financial indexes is followed by a summary of the research and important findings concerning the DJIA in the conclusion.

Overview and History of the Dow Jones Industrial Average

In May 1896, Charles Dow created what would become known as the Dow Jones Industrial Average or DJIA (Our company, 2016) by using the closing prices of a dozen of the leading stocks (Rosenberg, 1992). By January 2, 1897, Dow Jones was publishing averages for railroad stocks and using the recently invented telegraph ticker to broadcast financial news (Rosenberg, 1992). Because the index is based on the leading publicly traded equity issues in the United States (Hora & Jalbert, 2009), the constituent components of the DJIA have changed frequently since its inception more than 110 years ago (Hora & Jalbert, 2009). At present, the DJIA is comprised of 26 such publicly traded equity issues as shown at Appendix A ranging alphabetically from Apple, Inc. to Exxon Mobil Corporation.

Based on his exhaustive analyses of financial cycles, Dow was able to formulate an indexing framework in which the DJIA became an important indicator of the financial health of the American business community. In this regard, one biographer notes that, "A longtime student of financial cycles, Dow made observations that led him to devise an ingenious barometer of the relationship between stock market trends and general business activity" (Rosenberg, 1992, p. 13). The eponymous theory developed by Dow was founded on the price activities of the constituent stocks that comprised the DJIA meaning that to the extent that industrial average reached unprecedented highs or lows would be the extent to which the so-called "rail average" (known as the "transport index" today) followed suit (Rosenberg, 1992).

In addition, Dow believed that the performance trends of these constituent equity issues would serve as an indicator of the performance of the rest of the market (Rosenberg, 1992). For instance, according to Rosenburg, "Since these two averages represented two major areas of investment, it was Dow's belief that unless they both shifted in the same direction at the same time, the move could not be considered critical" (1992, p. 13). In sum, Dow maintained that relatively minor movements in either direction were merely transient or anomalous events that did not reflect the true status of the financial markets (Rosenberg, 1992). In addition, Dow also posited that if the industrial and rail averages both moved to unprecedented high levels, there was a bullish trend taking place and vice versa for a bear market (Rosenberg, 1992).

The industrial and transport indexes have both experienced significant changes over the years, and these indexes provide the same indication of economic activity as they did in the past having been supplanted by newer, more innovative and sophisticated forecasting methods that use computer-based applications (Rosenberg, 1992). Notwithstanding these trends, though, the DJIA remains an important measure of the direction of movement in the financial markets and an oft-cited source among analysts (Rosenberg, 1992). In this regard, Rosenberg concludes that, "Nevertheless, a number of financial experts still swear by 'the Dow,' and some investment-advisory services continue to view it as an important indicator" (1992, p. 14). It is noteworthy that Dow never expected this lofty status for his model when he developed it and he believed that the index was useful only as a framework in which to gain a better understanding of market forces and activities. In this regard, Rosenberg (1992) points out that, "Charles Dow never intended his theory to be used as the sole predictor of economic ups and downs.

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He saw it simply as a tool, an instrument that could be helpful in providing sound guidance to an investor's overall business and market strategy" (1992, p. 14).

Despite this original intention, the DJIA has become a bellwether of the health of financial markets in the United States today. Indeed, some indication of this influence can be discerned from market activity in response to changes in the DJIA. For instance, Shiller (2000) argues that, "A possibly significant factor behind the 1960s market peak was the Dow's approach to 1,000" (p. 110). In a case of the cart driving the horse, Shiller (2000) believes that the heavy reliance on the DJIA served as a self-fulfilling catalyst for investors despite Dow's original intent for his index. In this regard, Shiller concludes that, "That the approach of a new milestone such as a four-digit Dow would have an impact on the public imagination may seem silly, but . . . talk of such an arbitrary level provided a solid anchor for people's expectations" (p. 110).

Indeed, even the mainstream media bought into the unprecedented milestones being reached by the DJIA during the 1960s, a process that served to lend further credibility to the index. For example, as the DJIA approached the seemingly magical one thousand level, the editors of Newsweek reported that, "The 900 barrier had reached almost mystical significance in the minds of many observers" (cited in Shiller, 2000, p. 111). By the late 1970s and 1980s, faith in the accuracy of the DJIA in forecasting market trends became firmly entrenched in the fabric of American investments and the minds of financial analysts (Forde, 1986). In this regard, Haensly and Niranjan (2001) report that, "The Dow Jones Industrial Average is the most widely followed stock market index in the United States. Many people intuitively use the DJIA as an indicator for performance in the broad market" (p. 102). Taken together, it is clear that the DJIA has become a vitally important financial index that continues to influence investors. Some observers, though, question this continuing relevance and utility given that the DJIA is a price-weighted index that relies on fewer than 30 stocks compared to the more robust weighted measures provided by the S&P 500 index of 500 of the more than 2800 different company stocks that trade on the New York Stock Exchange (NYSE) today, and these issues are discussed further below.

Critical Evaluation of the DJIA Compared to Other Financial Indexes

There are a number of different financial indices in use today, including the DJIA, Standards and Poor's (S&P) 500 and NASDAQ, among others. Despite their differences, all financial indices seek to "provide a summary of the overall market by tracking some of the top stocks within that market [by providing] a representative snapshot that shows the direction that the overall market is headed" (Pant, 2016, para. 2). The DJIA experienced a significant expansion in July 2012 when it merged with the S&P Indices to become the largest global provider of financial market news (Our company, 2016). This merger served to expand the ability of Dow Jones to report the stock performance results of a far greater number of equity issues. For example, according to the Dow Jones' Web site:

Today, more assets are invested in products based on our indices than any other provider in the world. With over 1 million indices covering a wide range of asset classes and strategies across the globe, we continue to define the way investors measure and trade the markets. (Our company, 2016, para. 3)

Despite the merger, there are still some fundamental differences between the DJIA and S&P 500 that affect the reporting of financial news by these respective services, including the following. The constituent components of the DJIA are selected by a panel from the Wall Street Journal and the results of their performance are evaluated using straightforward mathematical averages (Differences between DJIA and S&P 500, 2016). In addition, stocks that a priced higher tend to affect the DJIA average more than lower-priced stocks (Differences between DJIA and S&P 500, 2016). By contrast, the 500 North American stocks used by the S&P 500 are selected by an S&P board and provide a wider range of representation from different industrial sectors (Differences between DJIA & S&P 500, 2016).

Moreover, rather than using simple mathematical averages as with the DJIA, the S&P 500.....

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