Although the headlines that dominated the international media last week related to the first few days in office of new US President Donald Trump, the international financial media gave ample exposure to the fact that one of the main equity indices in the US – the Dow Jones Industrial Average (DJIA) – surpassed the 20,000 level for the first time ever.
The origins of the DJIA, more commonly referred to simply as the “Dow”, go back some 130 years when American financial journalists Charles Dow and Edward Jones came up with the idea of creating an average reflecting the overall performance of the US equity market. Today, together with the S&P 500 and the tech-heavy NASDAQ Composite, the Dow is one of the most closely-watched indices in the US and across the entire financial world.
The Dow is composed of only 30 blue-chip American companies considered to be titans in their respective fields of operation. In aggregate, these 30 companies have a market capitalisation of over $5.7 trillion, generate annual revenues of over $2.7 trillion and employ over 6.5 million people. Among the Dow’s constituents there are some very familiar names like Coca-Cola, Apple, IBM, McDonald’s, Microsoft, Nike and Visa. These are just a few of the companies included in the index. Most of the products and services of these 30 companies naturally feature prominently in the daily lives of most people across the world.
Furthermore, the top three Fortune 500 companies – which is a list of the most revenue-generating companies in the world representing approximately two-thirds of the gross domestic product (GDP) of the US – are also included in the Dow. These are the world’s largest private employer – Walmart; the American multinational oil and gas corporation ExxonMobil; and Apple – the most valuable company in the world with a market capitalisation of over $600 billion.
One of the interesting but mostly criticised features of the Dow is that it is a price-weighted market index and as such, it is impacted more by the movements in the share prices of companies which have a higher absolute share price than by others whose share price is lower-priced. Therefore, the Dow does not reflect the actual average of the share prices of its various components as is the case with most other indices across the world.
In view of the highly critical weighting by share price rather than by market capitalisation, the weighting of Goldman Sachs, for example, is eight times more than that of General Electric (Dow’s oldest component), even though GE has roughly triple the market cap of Goldman. This is due to the fact that the share price of Goldman Sachs trades at circa $240 while General Electric’s share price is circa $30. Moreover, according to the Dow, IBM which is currently priced at circa $170, is still a much more important company than Apple whose share price is in the region of $120 although IBM’s market cap of $167 billion is a far cry from that of Apple at circa $650 billion.
Although many critics claim that the Dow is a limited yardstick of the performance of the US stock market since it is a price-weighted gauge of just 30 blue-chip stocks, it is still an important overall indicator to the investing public and the index features prominently on international headlines on a daily basis.
One of the best known prophecies across US financial circles is the “Curse of the Dow” which refers to a popular belief that the companies that join the Dow Jones Industrial Average normally tend to underperform the ones they replace. Market observers claim that by the time a company is important enough to merit inclusion in this index, it has a tough time living up to expectations. Naturally this does not always apply. However, the last time that a change was made to the composition of the Dow on March 19, 2015, Apple replaced the multi-national telecoms conglomerate AT&T. Less than six weeks after being included in the Dow, the share price of Apple rallied to a new all-time high of $134.54. However, the share price of Apple lost over 30 per cent in the following 12 months, until it started to recover again and is currently trading at around the $120 level.
Following last week’s eventful milestone for the Dow, many analysts are now eyeing the actual policies being enacted and implemented by the new US administration
Interesting too are the numerous milestones of the Dow since inception. It took just over 14 years for the Dow to double from a reading of 1,000 points in November 1972 to 2,000 points in January 1987, but only three years and four months to rally from 5,000 points in November 1995 to 10,000 points in March 1999. Thereafter, however, it took just under 18 years to double again from 10,000 to 20,000 points as the Dow suffered three major bear markets over the past 18 years.
After peaking at 11,750 points in mid-January 2000, the Dow and the other major US indices went through short periods of high volatility following the bursting of the dot-com bubble (the worst hit in this respect was the Nasdaq Composite index) and the September 11, 2001 terrorist attacks on the twin towers of the World Trade Centre in New York. In fact, in a span of less than two years, the Dow hit a low of 7,197 points on October 10, 2002, representing a slump of nearly 40 per cent from the January 2000 high. Subsequently, the 2002-2007 bull market followed, taking the Dow just past the 14,000 points level by October 1, 2007 only to fall back to 6,500 points in early March 2009 following the well-documented events leading up to the international financial crisis which culminated in the bankruptcy of Lehman Brothers on September 15, 2008.
Following the sharp rally since the lows of 2009, it took only 64 days for the Dow to reach 20,000 points after surpassing the 19,000 mark for the first time on November 22, 2016.
So what was the major contributor to the rally? The Dow climbed by 9.5 per cent from 18,332.74 points on US election day to 20,068.51 points on January 25, 2017 – the day the index surpassed the 20,000 mark for the first time ever.
Equity markets rallied following Trump’s unexpected win in November as investors speculated that a Trump administration would lead to higher infrastructure spending, looser financial regulations and also cuts in corporate taxes. Shares of banks and other cyclical companies climbed on hopes that a mix of tax cuts and fiscal stimulus from the Trump administration will accelerate economic growth and inflation and thus lead to higher rates of interest.
Goldman Sachs has accounted for 379 points of the Dow’s 1,736-point march higher since US election day as its shares have climbed by 30.4 per cent. Boeing, the aerospace group, has contributed 172 points as this equity gained 17.7 per cent and the IT company IBM added 158 points to the Dow after its share price advanced by 14.9 per cent.
These companies exert the most influence on the performance of the Dow due to their respective elevated share prices in absolute terms.
Over the past three months, only five equities performed negatively, namely Wal-Mart (-4.2 per cent); Johnson & Johnson (-3.6 per cent); Coca-Cola (-1.8 per cent); Cisco (-1.0 per cent); and Procter & Gamble (-0.3 per cent).
While the Dow increased by 9.5 per cent between November 8, 2016 and January 25, 2017, other equity indices in the US trailed behind as the S&P 500 and the Nasdaq 100 only gained 7.4 per cent and 7.2 per cent respectively. Meanwhile, other indices across the world performed better. Germany’s DAX shot-up by 12.6 per cent, Japan’s Nikkei 225 added 11 per cent and the Euro Stoxx 50 advanced by 10 per cent.
Although the Dow is normally given wide coverage across financial journals worldwide, due to the small number of constituents included in the index and the critical price-weighting of the index, the S&P 500, which is based on market capitalisation, is far more relevant to investors and analysts since it captures a much broader spectrum of corporate America.
Following last week’s eventful milestone for the Dow, many analysts are now eyeing the actual policies being enacted and implemented by the new US administration. Meanwhile, other financial observers continue to highlight that equity markets have increased significantly over the past eight years – a time frame which is over twice the average duration of previous bull markets.
In fact, foreign research sources last week published some interesting statistics on the frequency of corrections in stock markets. Data compiled since 1932 indicates that the S&P 500 index suffers a five per cent drop every seven months; a 10 per cent decline every 26 months and a 20 per cent correction into bear market territory every 3.8 years (45 months).
The last 20 per cent correction took place during the financial crisis of 2008/2009 and the main US indices have not suffered a five per cent correction in almost a year.
History is therefore suggesting that a market correction of at least five per cent is now well overdue.
Edward Rizzo is a director at Rizzo, Farrugia & Co (Stockbrokers) Limited.
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