What does the value of the Dow Jones represent?

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By Mike Moffatt,

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If you read the newspaper, listen to the radio, or watch the nightly news on television, you'll probably hear about what happened to "the market" today. It's all fine and good that the Dow Jones finished up 35 points to close at 8738, but what does that mean?

The Dow Jones Industrial Average (DJI), commonly just referred to as "The Dow", is an average of the price of 30 stocks. The stocks represent 30 of the largest and most widely traded stocks in the United States. The Dow Jones Corporation, the administrators of the index, changes the stocks in the index from time to time. On November 22, 2002, the following 30 stocks were components of the index:
3M, Alcoa, American Express, AT&T, Boeing, Caterpillar, Citigroup, Coca-Cola, E.I. DuPont de Nemours, Eastman Kodak, Exxon Mobil, General Electric, General Motors, Hewlett-Packard, Home Depot, Honeywell, Intel, IBM, International Paper, J.P. Morgan Chase, Johnson & Johnson, McDonald's, Merck & Co., Microsoft, Philip Morris, Procter & Gamble, SBC Communications, United Technologies, Wal-Mart, and Walt Disney.

The Dow Jones Industrial Average is computed by taking the average price of the 30 stocks and dividing that figure by a number called the divisor. The divisor is there to take into account stock splits and mergers. Otherwise the index would decrease whenever a stock split took place. Suppose a stock on the index worth $100 splits is split or divided into two stocks each worth $50. If we did not take into account that there are twice as many shares in that company as before the DJI would be $50 lower than before the stock split because one share is now worth $50 instead of $100.

The divisor is determined by weights placed on all the stocks (due to these mergers and acquisitions) and changes quite often; at November 22, 2002 the divisor was equal to 0.14585278. So if you took the average cost of each of these stocks on November 22 and divided this number by 0.14585278, you'd get the closing value of the DJI on that date which was 8804.84. You can also use this divisor to see how an individual stock influences the average. If the price of International Paper increases by two points, the DJI would increase by 13.7 points assuming none of the other stock values changed (13.7 = 2 / 0.14585278). Because of the formula used by the Dow a one point increase or decrease by any stock will have the same affect, which is not the case for all indices.

So the Dow Jones number you hear in the news each night is simply this weighted average of stock prices. Because of this, the Dow Jones Industrial Average should just be considered a price in itself. So when you hear that the Dow Jones went up 35 points, it just means that to buy these stocks (taking into account the divisor) at 4:00pm today (the closing time of the market) it would have cost 35 more dollars than it would have cost to buy the stocks the day before at the same time. That's all there is to it.

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Blogger comment:

The more the Dow go up the more the people who have stocks have more money. Thus the more the wealth they have and since millions of Americans own stocks which present significant part of their investments and retirement the more the price go up the more our wealth as a country. The opposite is true.

The stock market is very dynamic. Money is transferred in minutes by one computer stroke and in large volumes. It moves between banks and stocks, between stock markets all over the world and between stocks and commodities. It also moves form a currency to other one in a fast rate.
The market is too dynamic that we do not even understand it.

People as they invest in the market see only one part of the curve like in the housing market they see the part of the curve as prices go up. They do not know when the curve will start to go down. The psychology many of the times control investment then logic as Mr. Greenspan the previous Fed Chairman called it the irrational exuberance.

Because the market is very dynamic and is global people chase profits anywhere. America is particularly looked at since it has strong economy and stability for lone years. Thus money came as loans from all over the world to the banks and mortgage companies that are protected by insurance companies. As house prices went down and people economics are low and selling a house will be with loss people could not afford the mortgage or able to sell the house and the mortgage is defaulted and foreclosures happen.

Banks and insurance companies that are unable to pay back the people who supplied them with the loans are now bankrupted and the country has to bail them out or buy these bad loans or even buy them or buy in them. The country is not only USA but many countries all over the world. Since capital as we say is coward it moves to commodities or even under the mattress until the market rebound. Thus the stock market and other markets in the world see people buying less and selling more. Thus more people are selling so price go down. Some people are good in knowing the real value of a stock and hence they buy it at certain price, others are looking to see a bottom for the price and start to buy. The worse is people who do not trust the market and continue to get out of the market or even the markets. Everyone is not trusting if he will give his money to someone else he will loose it in declining shares or bankrupting banks.

Thus the credit decline and may even crunch. There is no enough money to go around and make the economy work. The plan now is to inject money to save banks and keep money going around and credit line alive. The main problem with that is printing more money that will increase the prices of goods and services more and creating more inflation. Nothing is more serious than inflation with increase prices in a contracted economy with less goods and services that cause prices to spiral up more.

Thus injecting money may help like the pain medicine to smooth the pain but we will ultimately need to know the cause of pain to treat it right. The four main things that cause the economy difficult to predict are: no real value to money like the gold standard in the old days, the money supply through the Fed which causes confusion, the interest rate that hinders real investments and real value to money and the bubbles.

Thus markets have to come together for new economic system where the currencies have corresponding value like Gold, no interest but fees for money that banks will compete for lower fees, absent of money supply from fed but by creating constant middle class lower and upper that will have the bulk of money and always look for demand, they will be actually owner of stocks and will provide the supply side as well. The bubbles will need active supervision from the government or the market administrators to detect it early and encourage diversification.