Dow 12k - Much Ado About Nothing
Note: this post was carried today on Wallstrip
Overview
As usual, leave it to mainstream media to use hyperbole (in the absence of substance) in order to sell papers. The hype around Dow 12k is so out of proportion with its true information content as to be laughable. And I’m not alone in this assessment, though some might express this opinion in a more poigniant, eloquent manner than myself. Al Goldman, the chief market strategist at A.G. Edwards, deftly stated: “This is much ado about nothing, as Shakespeare would say. The important thing is not for the Dow getting above 12,000 but what it took to get us up here and why we got here.” Good question, Al. Let’s take a little time and space to analyze that very question. But first, a little background on our friend the Dow (interchangeably referred to as the DJIA).
The Dow: A Flawed Benchmark
A quick refresher of its definition in Wikipedia gives us a flavor for why the DJIA is not necessarily the benchmark investors, politicians and the public alike should be focusing on when describing overall equity market performance:
The DJIA is criticized for being a price-weighted average, which gives relatively higher-priced stocks more influence over the average than their lower-priced counterparts. This can produce misleading results, as a $1 increase in a lower-priced stock can be negated by a $1 decrease in a much higher-priced stock, even though the first stock experienced a larger percentage change. Additionally, the inclusion of only 30 stocks in the average has brought on additional criticism of the average, as the DJIA is widely used as an indicator of overall market performance.
Many critics of the DJIA recommend the market-value weighted S&P 500 index as a better indicator of the wider economy.
Another issue with the Dow is that not all 30 components open at the same time in the morning. Only a few components open at the start and the posted opening price of the Dow is determined by the price of those few components that open first and the previous day’s closing price of the remaining components that haven’t opened yet; therefore, the posted opening price on the Dow will always be close to the previous day’s closing price (which can be observed by looking at Dow price history) and will never accurately reflect the true opening prices of all its components. Thus, in terms of candlestick charting theory , the Dow’s posted opening price cannot be used in determining the condition of the market.The DJIA is criticized for being a price-weighted average, which gives relatively higher-priced stocks more influence over the average than their lower-priced counterparts. This can produce misleading results, as a $1 increase in a lower-priced stock can be negated by a $1 decrease in a much higher-priced stock, even though the first stock experienced a larger percentage change. Additionally, the inclusion of only 30 stocks in the average has brought on additional criticism of the average, as the DJIA is widely used as an indicator of overall market performance.
Objective analysis, however, does not always carry the day, and there is definite “buzz” value around the Dow crossing these millennium milestones.
The Dow: A Guidepost for the Uneducated, Impressionable and Opinionated
We’ve seen this movie before - and it was Dow 11k. Adam Shell of USA Today wrote a piece that specifically raised the issue of psychology of the Dow hitting new, round price levels.
NEW YORK — The Dow did it — finally! It’s back above 11,000! First time in 4½ years!
What’s an investor to do? Dig out the moth-infested rally cap from the attic and run with the bulls? Or shrug off the latest Dow mania and side with the bears hunkered down in been-there, done-that mode?
That’s the newest debate on Wall Street. Investors are trying to decipher how the market will react to the Dow Jones industrials’ latest foray above 11,000. Like Dow 1,000 and Dow 10,000, Dow 11,000 is a big, round, headline-friendly number with psychological clout that has proved difficult to hold in the past.
Optimists argue that the Dow’s ability to crack the 11,000 milestone for the first time since June 7, 2001, could be a big momentum-builder. They say it could mark an end to the go-nowhere trading range, spark an upside breakout — even serve as a stepping stone to a new high or Dow 12,000.
I mean, come on, this is just stupid. A flawed index hitting a round number with the rationale for its continuing its ascent being a sort of rah-rah “Here we are, recovered from the wounds of five years ago” thing? This is why individuals who don’t know what they’re doing should stay out of single stocks. Just when things start to get exciting…. Now what about the reaction to Dow 12k?
Bottom line - the Dow crossing 1000-point barriers has become a time for celebration. Particularly for those with an agenda or a spleen to vent. On October 18th, when CNNMoney.com released the first major news article on the Dow’s new intraday record, reaction was nothing less than partisan:
“But according the the Democrats the sky is falling and Bush is ruining the economy not to mention the Corporations are Corporating!.”
“Wow, it only took 6 years to get back up past Clinton levels.”
“I’m rich, bitch!”
“The stocks doing well is a sign of a strong economy, which is great! However, it doesn’t mean that the budget deficit has disappeared. We owe a China and Japan a LOT of money.”
“The 90s economy was good despite Clinton, not because of him.”
“I blame Bush.”
“Economy is improving but wages aren’t. YAY!!!”
Yeah, whatever.
The Dow: A Tool for Spin-meisters and the Press
Slate’s Daniel Gross’s article on Dow 12k was pretty good, notwithstanding its political overtones (undertones, whatever):
So far, Republican candidates don’t seem to be benefiting from the Dow record, which is less surprising than it seems.
For starters, the Dow’s success does not mean that stock-market investors in general are thriving, because the Dow does not well represent the whole market. The Dow has a long and distinguished history, and remains the most popular shorthand for the performance of the stock markets. But as an overall stock-market proxy and investment tool, it’s an also-ran. The 30 stocks in the Dow Jones industrial average are huge, important, and widely held. But the index only accounts for less than one-quarter of the market. And because of its weighting system, the performance of a few stocks can have a disproportionate impact. In late September, blogger/money manager Barry Ritholtz broke down the performance of the individual Dow components since January 2000. The numbers show that a) most components are still way down from their peaks; and b) the torrid performance of a handful of stocks accounted for most of the index’s gains.
The Dow: You’re Gonna Get Hurt
Michael Nystrom from the blog Bull! Not Bull, who seems to have a clue, discusses Dow 12k in the context of a less-enlightened friend after reading Livermore’s legendary book Reminiscences of a Stock Operator:
How far will the Dow go, and how will it unwind? That is impossible to say, but it is certainly a profitable rally for those who know what they’re doing, and a sucker’s rally for those who don’t. Recently I was out to dinner with some friends, and one of them commented that while the Dow was making new highs, his stocks were not. I pointed out that that is to be expected because this is a very narrow rally. In the Dow’s Phony New High, I noted that even though the index itself is making new highs, most of its component stocks are not.
What should he do, my friend asked me. Should he switch his funds? What stocks should he buy?
As if I knew.
This rally in the Dow is clearly making novice investors nervous - nervous because they feel they’re being left behind. This is the difference between the novice and the pro. The pros (like Livermore, if he were with us today), are pushing this market up and the novices are awestruck on the sidelines. After seeing a few more days like we had today, with 100+ point days of gains, the novices will be convinced that this rally is for real, and will be falling all over themselves to get in on a piece of the action. Which is precisely what the pros will let them have - a piece of the action! Livermore might have ridden wheat up to $1.25, but you can bet he liquidated into the rally as the suckers got on board.
I tried in vain to explain all of this to my friend, and that he should sell all of his stocks and buy CDs, which he could not believe. He wasn’t going to settle for 5% — not when the Dow is making new highs! He didn’t want to hear anything of the sort, and so somehow changed the subject. Not many people are willing to listen to things they don’t want to hear. Had he been willing to listen, I would have told him what I am about to tell you: The current divergence between the financial economy and the real economy is setting up the shorting opportunity of a lifetime. Most “investors” today are unfortunately not sophisticated enough to understand how to take advantage of the coming opportunity.
Like Michael, I have no idea what is going to happen to the market from here. That said, I am confident that the fact the Dow crossed 12k has little to do with either the real economy or the general level of equity prices 6, 12 or 24 months forward. I just don’t see the linkage.
Conclusion: Much Ado About Nothing
So sit back, fill up a glass of champagne and let’s all toast the arrival of Dow 12k. It is about as much attention as it should get. Period.
Thanks to Rick Calmon for his assistance with this post.
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