The Dow Jones Industrial Average Is a Liar

The most cited number in financial journalism is a relic of an ancient era.

The Dow Jones Industrial Average (DJIA) was created in 1896 by the co-founder of the Wall Street Journal, Charles Dow. Dow wanted a way to summarize what was going on in the market for his publication, but it had to be a simple calculation he could do quickly by hand.

He selected 12 industrial stocks representing major sectors of the U.S. economy and calculated a price-weighted average to create his index. The DJIA is now composed of 30 stocks but still uses the same simple price-weighted method.

An index of that sort made some sense in that era when there was so little data available and far fewer stocks to consider. The DJIA has been used for 130 years and sits at the top of every front page and every television news segment about the stock market, not because it is accurate or helpful but due to habit and inertia.

Other indexes, such as the S&P 500 and the Nasdaq Composite, are constructed more sensibly based on the relative size of companies by market capitalization, but they have their own distortions. Just a handful of names move the entire average regardless of what the average stock may be doing.

When the mainstream media reports on the stock market, they almost always lead with one of these indexes. The reporting is so common and routine that even sophisticated readers absorb it without really thinking about it.

“The market was up today” means an index was up. “The market is bearish” means an index is dropping. The shorthand sounds reasonable but the tendency to believe these indexes are the essence of the market is misleading and hides many exceptional opportunities.

The Trap of Bullish or Bearish

The biggest problem with the common usage of the indexes is the all-or-nothing perception. Traders look at the headline number, decide the market is bullish or bearish based on its trajectory, and build their entire approach around that single judgment. We are seeing it in the current market environment where the bears are hyperventilating over how extended the indexes are without considering the many stocks that are not correlated with the indexes and may still offer good value or a great chart.

The simplistic view of the indexes is the market reduces a heterogeneous universe of thousands of stocks to a binary state, and every decision flows from the labels of bullish or bearish.

The reality is messier, more interesting, and far more profitable. On any given day, some large fraction of stocks moves against the index. On flat days you can have hundreds of stocks making new highs and hundreds making new lows at the same time. The index is one summary statistic of a wildly diverse distribution, and using it as a stand-in for that distribution erases the texture that matters most to a stock picker.

In my experience as a trader, some of the best trading is on days when the indexes are flat. The reason is that traders gravitate towards a smaller group of stocks and create strong short-term momentum.

Saying the market is bullish because the index is up is like saying the country is doing well economically because GDP grew. It might be true in aggregate, but it tells you nothing about whether your industry, your city, or your neighborhood is in better shape. The aggregate hides the details, and the details are where you find a trading edge.

How the Indexes Are Built

Most readers have never thought about how these indexes are constructed, and the construction is the source of the distortion. The DJIA is price weighted, which means a $400 stock has eight times the weight of a $50 stock regardless of the size of the company.

Currently, the stock with the most weight in the DJIA is The Goldman Sachs Group (GS) because it has the highest price at near $1,000. It has more than three times the weight of Apple (AAPL) because Apple is priced near $310. But if you look at market cap, Apple is roughly 15 times larger than Goldman Sachs, with a market value of $4.57 trillion versus $295 billion for Goldman.

By any logical standard, the price weighting scheme is absurd. Goldman has three times the influence on the DJIA as a stock that is 15 times larger. Inertia and tradition keep the absurdity intact.

The S&P 500 is market capitalization weighted, which is a more reasonable construction but creates its own concentration problem. At current weights, the top 10 stocks in the S&P 500 represent roughly 40% of the index. When those 10 names move, the index moves. When the other 490 move, the index barely notices. So when you watch the S&P 500, you are mostly watching 10 stocks pretend to be 500. The Nasdaq Composite is even more concentrated.

The headline index can be flying while the average stock languishes. Since the Covid low in March 2020, the cap-weighted S&P 500 is up roughly 235%. The equal-weight version of the same index, which gives every one of the 500 companies the same allocation, is up roughly 170%. The gap is almost entirely attributable to the Magnificent Seven.

The great irony is that anyone holding a standard diversified portfolio is likely to underperform a cap-weighted index. The only way to beat it is to hold only the mega-caps that are producing the outperformance. In other words, diversification and risk management are punished when trying to beat a benchmark index that is driven primarily by a few mega-cap names.

Why the Indexes Lag the Action

Rotations are where the opportunities and profits reside for active investors. These rotations show up in breadth and sector behavior long before they appear in the indexes.

New highs versus new lows reverse before the index reverses. Small-caps relative to large-caps signal risk appetite before the cap-weighted measures catch up. Sector leadership rotates among financials, semiconductors, industrials, and consumer names while the index sits flat, and the trader who watches only the index sees nothing happening.

The most important information in the market lives under the surface, and the indexes are not only the slowest to reflect it, they will actively hide it. By the time the media starts to notice a significant move in the DJIA or S&P 500, the move is well advanced and the better opportunities have already been captured by traders who were watching the internals.

When you focus on indexes, you are focused on a lagging summary instead of leading information, and you are deceived into believing it is the whole story.

Where the Opportunities Live

If the indexes mislead, where do you look instead? You look at the things the indexes cannot show you.

You watch sector ETFs. A semiconductor rally, a regional bank breakout, a biotech rotation. These appear in the sector measures weeks before they matter to the broader index, and you can position in the leading names while everyone else is debating whether the market is bullish or bearish.

You watch breadth. The advance-decline line, the percentage of stocks above their 50-day moving average, and the new highs versus new lows reading. These tell you whether the rally is broad and healthy or narrow and fragile, and they shift before the index does.

You watch individual stocks with their own catalysts. The biggest gains in any market are in names that the broader index does not even include or barely weights. A $500 million company that doubles is invisible to the S&P 500 but transformational to the trader who held it through the move. The trader who treats the indexes as the market is structurally excluded from the kinds of opportunities that produce the largest returns.

The Partial Truth That Keeps the Deception Alive

The indexes are not useless. When financial conditions tighten hard, the broad measures fall, and most stocks fall with them. When liquidity is abundant and risk appetite is high, the indexes rise and most stocks rise with them. There is correlation between the headline number and the average stock, and pretending otherwise would be dishonest.

The problem is the perception of identity. Readers see indexes up and assume everything is up. They see indexes down and assume everything is down. Even in trending markets, large parts of the universe are moving against the trend, and those parts are often where the better opportunities sit.

The argument is not that the indexes contain no information. The argument is that they are one input out of many, and treating them as the master variable is what blinds you to everything else.

The Contrarian Payoff

Since most people focus on the indexes, that means the indexes are the most efficiently priced and most heavily watched part of the market. The best opportunities to make money live on the fringes, where fewer eyes are looking. Asymmetrical opportunity develops when everyone is obsessed with index direction.

You are not running a pension fund and you are not being measured against a benchmark by a board of trustees. You have the freedom to look anywhere in the market, hold any position size, ignore any name that does not interest you, and concentrate on the handful of setups that look the best at any given moment. That freedom is a structural advantage, but you only get to use it if you stop framing the market through a measurement built for someone else’s job.

The market is never simply bullish or bearish. It is always a mix with leaders, laggards, breakouts, breakdowns, rotations, and divergences happening simultaneously. The trader who sees the distribution finds opportunities in every kind of environment. The trader who sees only the index sees a binary, and the binary is wrong most of the time.

That is the index deception. The headline number is the most visible part of the market and the least informative part of your trading day. Stop letting it tell you what to think about the action, and start looking at the parts of the market that generate the returns.

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At the time of publication, Rev Shark had no positions in any securities mentioned.