Stock Market Implications

Written by Joe Driscoll

November 26, 2009

The dramatic run up of the stock market over the past several years and the ever more dramatic fall on Black Monday several weeks ago has heightened interest in financial news. One of the impacts of Black Monday has been for us to be kept posted on the hourly gyrations of the ubiquitous Dow Jones Average.

From the evening news to the morning paper and all commentators in between, we are constantly updated on its fluctuations and the impact that these fluctuations will be having on our lives. It is amusing that this best known financial average really isn’t an average of anything at all!

If the plummeting Dow will have a fraction of the negative consequences on the economy, our buying patterns and on our lives in general that the newscasters have advised us over the past several weeks, we should know what it represents and how it is computed.

Charles Henry Dow is credited with first compiling the forerunner to today’s Dow Jones Industrial Average in 1884. It started out as the listing of the closing price of eleven active stocks. The closing prices were simply added up and divided by the total number of companies on the list. Dow did not use a weighed mean or make any adjustments of any nature.

In 1916 the list was expanded to twenty companies and in 1928 it was expanded to the thirty companies that it represents today. While only thirty companies are represented in the Dow Jones average, they have been chosen because they are representative of American industry. Whenever any particular company becomes unrepresentative, a substitution is made and a corresponding adjustment to the average is calculated.

Over the years the Dow Jones so-called average has evolved to where it is no longer an average, but rather a market movement indicator. In an effort to maintain historical continuity while adjusting for mergers, substitutions and stock splits, the so-called average is now computed by adding the closing price of the thirty stocks and dividing by a number that is just under 1.5.

The result of this manipulation, done for historical continuity, is that the “average” exaggerates market movements since it runs in points at a greater rate than the movement of an actual “average” price of an industrial stock.

Why does the Dow Jones “average” which only represents the indexed price movement of thirty stocks dominate all the business headlines? If it was sufficient to look at an average of thirty companies back in 1928, is it still sufficient to look at an index of of only thirty companies nearly 60 years later?

Today there are over 1800 companies whose stock is traded on the New York Stock Exchange, over 1200 traded on the American Stock Exchange and ten of thousands of companies whose stock is traded on the regional exchanges and the over the counter market. There are other indicators which are more representative of this substantial market than the indexed “average” of the 30 Dow Jones companies.

The Standard & Poors 500 index, commonly referred to as the S&P 500, tracks 500 different companies that trade on the New York and American Exchanges and the over the counter market. These 500 companies include 400 industrial, 40 utility, 40 financial and 20 transportation businesses.

The diverse coverage of the S&P index gives a broader view of the market. In addition to being more representative of the thousands of publicly traded stocks, another advantage to the S&P index is that it is market-value weighted rather rather than price weighted. This is achieved by multiplying a stock’s market price by the number of shares outstanding. This limits each companies influence on the index in proportion to its importance in the market.

The Wilshire 5000 is another broad based index that tracks market values in the NYSE, ASE and the OTC market. There is a separate index for each of the two exchanges and a NASDAQ OTC index for the over the counter market. Regardless of which index you measured during the past several weeks, the direction has been south.

Many of the implications of the downward trends in the market are obvious. One of the potentially more serious impacts could be the difficulty which growing businesses may encounter in raising equity capital. It is the emerging businesses that supply the growth, technology, jobs and innovation on which our economy grows. It is important that the disruption in the equity markets does not cause this sector of the economy to have its growth stunted by an inability to secure needed equity capital.

Because it’s your business, keep an eye on the true market indicators and an eye out for the emerging growth companies that will lead the economy in the coming decade.

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