Why The Dow's New Highs Aren't New At All
“This week the Dow Jones industrial average has been hitting all-time highs.” – Paul Krugman, New York Times, March 8, 2013
Unfortunately, the Times’ Nobel Laureate is perpetuating a misperception that haunts investors in two ways. He is ignoring dividend income, and implying that 30 securities chosen by a committee represent the U.S. equity market. He would make his case better if he chose his indexes more carefully.
The new highs in the Dow Jones industrial average are old news—nearly 14 months old. On a total return basis, including dividend payments and the compounding from reinvesting them, the Dow, and the SPDR Dow Jones Industrial Average Trust (DIA), the ETF that tracks it, regained its October 2007 high on Jan. 19, 2012. As of March 7 of this year, DIA’s total return level was already 13.5 percent above its 2007 highs.
Krugman took the easy path of quoting the price levels of the index. The commonly quoted price-only version of the Dow Jones measures today’s price of the Dow 30 stocks, and compares it to past prices.
But every one of the Dow 30 stocks pays dividends. DIA’s trailing 12-month dividend yield is 2.32 percent as of March 7. Investors benefit from those dividends, either by taking the cash, or by reinvesting it back into the market. Historically—and crucially—dividends have contributed the lion’s share of equity market returns.
Total return indexes include dividends, as well as the compounding from reinvesting those cash flows back into the constituent securities. Indexers almost always publish both price and total return index levels, but the media likes simplicity, and price returns are simple.
There’s another reason to bristle at the “Dow Reaches New Highs” headlines. The Dow Jones industrial average doesn’t really represent the U.S. equity market. Look at this chart:
According to S'P Dow Jones Indices, the Dow Jones industrial average represents “large and well-known U.S. companies,” covering all industries except for transportation and utilities. It includes exactly 30 stocks, selected by a committee that looks for sustained growth, name recognition and reputational excellence. It’s weighted by price, not by market capitalization.
The Wilshire 5000, perhaps the broadest U.S. equity market index, contained 3,573 securities as of the end of February 2013. The Dow Jones industrial average follows less than 1 percent of that number. At IndexUniverse, we use the MSCI Investable Market Index series to approximate global equity markets. This week, the MSCI USA IMI index contained 2,449 holdings.
As it happens, the Dow 30 has outperformed the broad U.S. market over the past 13-plus years by a cumulative 40 percent, or 2.58 percent on an annualized basis, as of March 7, 2013. Outperformance is desirable in an investment, but not in the yardstick. Using the Dow Jones industrials as a proxy for the U.S. equity market overstates the stock market’s robustness.
In other circumstances, it could do the opposite.
There are many ways in which the Dow is atypical of the U.S. market. Here is a table comparing the weighted average market cap of funds tracking the DJIA and other popular-yet-unrepresentative indexes, and with the MSCI USA IMI:
Fund | Underlying Index | Weighted Average Market Cap 3/1/13 |
DIA | Dow Jones Industrial Average | $149.7 billion |
SPY | S'P 500 | $103.5 billion |
ONEQ | Nasdaq Composite | $85.6 billion |
— | MSCI USA IMI | $84.4 billion |
There are many ways in which the Dow is atypical of the U.S. market. A comparison between the weighted average market cap of funds tracking the DJIA and other popular-yet-unrepresentative indexes, and the MSCI USA IMI, shows just that.
In quoting the price-return version of an outperforming index, Paul Krugman has introduced two competing obfuscations into his argument. The Dow 30 is mega-caps, which have fared well since 2000. Anyone remember the 1990s, when the opposite was true?
Would Krugman have done better quoting either the S'P 500, or the Nasdaq Composite, which NYT.com quotes on its home page, in their price-only versions? Unfortunately, none of the headline indexes delivers a complete or unbiased view.
The S'P 500 comes closest, despite its large-cap orientation. S'P’s index committee selects “500 leading companies in leading industries of the U.S. economy,” according to S'P’s current fact sheet.
The committee’s goal is to “ensure that the S'P 500 remains a leading indicator of U.S. equities, reflecting the risk and return characteristics of the broader large cap universe” (italics mine). Some household names, like Facebook and GM, don’t make the cut, but midcap companies, like Advanced Micro Devices, which ranks 1,154 th in market cap, do.
In the end, the S'P 500 gives an edited view of the U.S. marketplace. It claims to cover large-caps, but holds plenty of midcaps. Since 2000, the S'P has outperformed the MSCI USA IMI by 0.31 percentage points annually.
The Nasdaq composite measures the performance of all equities listed on the Nasdaq. A full 45 percent of its weight is in technology, with 8.3 percent in AAPL alone.
At IndexUniverse, we use the MSCI Investable Markets series to measure the returns of global equity markets, because these indexes cover 98 percent of the market cap in every country, with only light adjustments for liquidity and free float. It’s investable, and has sensible breaks between large-, mid- and small-cap companies.
We don’t let our writers or analysts quote price-only indexes, because we understand the power of compound interest. If the New York Times and the rest of the nation’s news outlets would do the same, investors around the world would get a truer picture of the state of our equity markets.
Paul Krugman wanted to press the point that the U.S. equity market is healthy.
The MSCI USA IMI Total Gross Return Index regained its 2007 high last March, and is now 11.9 percent above its old high-water mark. If Krugman chose his indexes wisely, he would make his point more forcefully. Don’t you make the same mistake.
At the time this article was written, the author held no positions in the securities mentioned. Contact Elisabeth Kashner at ekashner@indexuniverse.com.
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