Morning Monkeys,
Back in September 2012, In The Flesh made some great points about why the DJIA is a worthless piece of garbage; concluding that the S&P 500 is a far more useful measure of the market. ITF makes some pretty solid points to arrive at said conclusion: It's only 29% of total market cap, it's price weighted, and stock splits cause all sorts of trouble. All great points, and all absolutely correct. But, in practice, how does the DJIA compare to the S&P 500?
Well, from what I'm looking at, in practice, the two are nearly identical. In short, look at either, they both tell the same story. To illustrate:
But, regrettably, eyeballing a graph is hardly rigorous analysis, so let's try to attach some values to this bad boy. A good place to start is finding out just how correlated are the DJIA and S&P 500. Using data from the beginning of 1992 to present, the correlation of the two's daily percent change is 0.96163. That's nothing to sneeze at, but it doesn't explain why two very different indexes, structured in very different ways, appear to reflect a market's condition very similarly.
A common point made is that the DJIA captures a mere 29% of total US market cap while the S&P 500 captures upwards of 89%. This is a huge gap, and certainly an initial cause of concern, but to what degree is it problematic? Using S&P's GICS sector classification, we notice that while the DJIA captures far less market cap than the S&P 500, it captures 90% of the possible sectors (granted, this is compared to 100% for the S&P 500) which, could explain the two's extremely high correlation.
Another point made by ITF and others is that price weighted indexes are inferior to market cap indexes. This suggests, correctly, that splits and reverse splits should cause numerous problems for the price weighted index when compared ot the market cap index. But, looking over the long term, starting in August of 1958, we see that there's still an amazing degree of similarities between the two:
In fact, looking from this perspective, it appears that the S&P 500 valued the markets much higher prior to entering into a recession, with the DJIA being the more conservative index.
So, while this analysis leaves something to be desired (anyone want to toss in some math?), I believe there's enough evidence here to come to a conclusion. ITF's analysis of the DJIA being useless is absolutely correct. But, from where I'm sitting, the S&P 500 is equally useless, as it's purported superiority doesn't appear as you would expect when looking at the actual data.
What do you monkeys think? If you agree, what's a better way of measuring the market? If you disagree, what am I missing?
In simplicity terms the two are highly correlated because S&P contains all the Dow stocks. On top of that the remaining S&P stocks trade very well correlated to each other and markets in generally. You take that and add quant systems that trade on arbitrage and correlations and you have them extremely well correlated. Hell the Dow and Nasdaq are well correlated despite the small overlap. I can't believe we are going back to Finance 101 and trying to make something more complicated than it truly is. The only real differences between the indices is merely just the beta for the most part and the common rotation that you see year to year in terms of market caps and sectors ( good years in small caps are sometimes followed with good years in large caps etc....). Obviously I could continue on and on.... but this is something Id rather not do.
Also you cannot make the fact that the Dow is a more conservative index purely on fact that it went much higher in 2007. You need to remember that it has older more established companies and as a result is heavily weighted on less volatile companies due to their size. Large caps with established businesses and little growth tend to move less than the small cap with growth potential. Also, the Dow would only need a few stocks like Exxon, IBM, and Chevron to perform well for it greatly outperform the S&P.
This is not correct. The differences between the two indicies are substantial and said differences should produce a meaningful difference between the two. While you're right that the DJIA is a subset of the S&P 500, but the simple fact that the DJIA is a price index and the S&P 500 is a market cap index absolutely creates a massive distinction in how the different stocks within the indicies are treated. It is indeed peculiar that the two of them are correlated as much as they are given this fact.
Yes you are correct. I forgot to remention yes price versus market indices are different(you took care of it above). The difference in performance is only the beta factor. My point is that unless the heavily weighted factors in Dow due to being a price index become so lopsided that it becomes the new Apple of Nasdaq 100, then the Dow and S&P will continue to be highly correlated due to correlations in the market. Price versus market are different but in order for a significant difference to be seen you really need to see one or more stocks run wild while rest of market does not. This will create a greater impact in DJI.
Look at the Russell vs Dow (or even SPX) if you want a more 'look at the difference!!1' type of comparison.
the one on the left, surely, but they both look like solid contenders
I'd stock split her index with my market cap
The fact that the DJIA is a price-weighted index is reason alone for me to not take it seriously.
MSFT trades at ~28 and has a market cap of $232 bn MMM trades at ~103 and has a market cap of $71bn
The fact that MMM can have a roughly 4x bigger impact on the movements of the DOW is completely ludicrous and as such I don't really follow what the DOW is doing.
It's not surprising in the least that these two indices are highly correlated. It only means that they're moving in the same direction at the same time. Every stock index is going to be highly correlated to one another (caveat being you have to make sure you measure the closing prices at the same time, which matters when comparing stocks from different countries). High correlation does not necessarily mean the same performance.
You'll notice there was a massive divergence in these two indices around the Internet bubble. At the time there was a massive divergence between tech stock performance and everything else. The Dow had no exposure to the biggest bubble type companies. If you change the starting and ending dates on the graph, they can look more dissimilar.
The Dow is a relic. It's computed that way because it was the easiest way to compute the average on a chalkboard.
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