Why the hoopla over Dow 20,000?

“Dow 36,000” was the title of a popular press book on the stock market published in 1999. Authors James Glassman and Kevin Hassett predicted that the Dow Jones Industrial Average would rise to 36,000 within a few years. Of course, the dot com bubble, 9/11, and the financial crisis led to a lost decade of stock returns.

Here we are less than 20 years later approaching a big, round number on the world’s most celebrated index, and many investors and pundits are on the edges of their seats.  

The singular obsession of the financial markets the last few weeks has been the Dow failing to break 20,000 points. The index came within a whisker—less than 13 points—of reaching 20,000 two weeks ago and has since languished below the elusive level.

While it is not surprising that the financial news focus coverage on this phenomenon, the quest for 20,000 pervades the popular culture. Dow 20,000 hats are a popular seller on eBay.

Market professionals recognize that the importance of the index is only exceeded by its many flaws. The fact that people still follow the Dow is a vestige of history. It was one of the earliest stock market indices, with its first industrial average calculation in May 1896.

To remark that the Dow is an unusual index is akin to observing that Bob Dylan has an unusual performance style. A good stock index is representative of the broad market, includes stocks from disparate industries, and is weighted appropriately. Ironically, the Dow fails on each one of these considerations.

The Dow is a very narrow index as it limited to only 30 stocks. By contrast, the S&P 500 includes 500 companies. While the size of the firms in the Dow are enormous, the index covers less than 25 percent of the U.S. stock market. The S&P 500 incorporates roughly 70 percent of the total U.S. stock market.

{mosads}About 55 percent of the Dow’s component companies are in the financial services, industrial and consumer cyclicals industries. Those same industries represent a little more than one-third of the S&P 500’s component companies.

It seems ironic that the largest industry representation in the Dow is financial services, with more than a 20 percent weighting in this sector. When one thinks of industrial companies, Goldman Sachs, JPMorgan Chase and American Express do not immediately come to mind.

The quirkiest part of the Dow index, and its greatest flaw, is its weighting scheme. The Dow is a price-weighted index, meaning that the highest priced stocks have the greatest impact and the lowest priced stocks have the least impact. Goldman Sachs currently represents more than 8 percent of the Dow, while Cisco Systems is about 1 percent of the index. This is illogical: Cisco is roughly 50 percent larger than Goldman Sachs in terms of market capitalization, or stock price times number of shares outstanding.

Stocks in the S&P 500, on the other hand, are weighted by their size. Apple is the largest component of the S&P 500. It is nearly seven times the size of Goldman Sachs and gets nearly seven times the weight in that index.

When investors ask how the market did for the day, the response is often that the Dow rose or fell by “x” number of points. As the index has risen in value, a given point change means less and less. A 100-point move is worth roughly a half percent today, while it was approximately 5 percent at the time of the 1987 crash.

Given how flawed the index is, what is all the hoopla surrounding this index reaching a historic level? As Tevye sang in Fiddler on the Roof, “Tradition!”

Human beings are fascinated with big round numbers, and despite being an inferior index, investors focus on the Dow because we grew up with it.

The Dow will likely break through the 20,000 points in the near future. While it will be celebrated as a milestone, it shouldn’t be. The Dow will eclipse the 20,000 barrier because a few large stocks—not representative of the broader market—advanced a few points.

Once the barrier is eclipsed, the market will return to its normal state until the next big round number—either Dow 25,000 or Dow 15,000—is in sight.

Robert R. Johnson, PhD, CFA, CAIA, is president and CEO of The American College of Financial Services. He is co-author of Strategic Value Investing, Invest with the Fed, and Investment Banking for Dummies.

The views of Contributors are their own and are not the views of The Hill.