Sunday, April 27, 2008

How is the Dow Index Calculated?

Top Line: There seems to be an eerie calm in the air over Wall Street and that makes us nervous. The upcoming week contains several market moving opportunities being it's the end of the month what with the jobs' report due out on Friday. We think this will be a good week to get ourselves back on the short side.

To continue with that thought, the highs on Thursday held on Friday as MSFT tugged the indexes down. With the NASDAQ indexes being market cap weighted, MSFT dropping means a significant drag on them. As for its effect on the Dow, that's much less potent since the Dow is a price weighted index. Ok, we'll try to explain that...

The way the Dow is calculated is an "average" of the prices of all the Dow stocks. Just add up the prices of all 30 stocks and then divide by a number, called the divisor. That number reflects prior Dow stock splits. Let's say there are two stocks in the index and they are both 100. If we were to add them up, we would get 200 which we could call an index if we like. But, let's say that today's the day that one of them splits itself in two such that tomorrow it will be trading at 50, yes, there will be twice as many shares to the market value doesn't change.

Our index is a price weighted average but we don't want it to drop from 200 down to 150 in one day when nothing in particular happened. So, what we do is we change our divisor from 1 to whatever will make our new index the same as it was the day before, 200. One of our stocks is 100 and the other is now 50 and if we add that up we get 150. In order for us to divide by some number to get 200, we divide today's price by yesterday's to get the new divisor. 150 divided by 200 is 0.75 and now all we need to do is divide the new sum of 150 by 0.75 and we see that the index can still be 200, 150/0.75 is 200.

This calculation is the same way the Dow is calculated only with 30 stocks. We have shown you how the split calculation works but there is another time when the divisor changes. That time is when there is a change in the components of the Dow index. If they change out a stock and add a new one, they probably don't have the same price so a similar "rebalancing" would occur at that time. The calculation would be add the 30 stock prices up under both sets of components. Then a new divisor would be born and the process continues.

We are not too satisfied with the price weighted Dow index but that's the way it's been for as long as it has been in operation and our emotions will not be taken into account. Our problem with the method is not that it has to be market cap weighted because all of these stocks are large enough. Our problem is that they are not the same price level.

For example, PFE (there's our new friend, Pfizer) is trading right about 20 and IBM is trading just over 120. When PFE moves 10% it goes up 2 bucks but if IBM moves 10% it moves up 12 bucks. That 12 bucks is over half the weight of PFE in the total Dow index. Two 10% moves are definitely not equal in the index. With a divisor currently near 0.125 (you can find the real one in the WSJ, if you like) when a stock moves 1 point, the Dow moves 8 points, approximately. So, in our example, if PFE moves up 10% or $2, the Dow will move up about 16 points but if IBM moves up 10% or $12 the Dow will move up 96 points.

Getting back to MSFT's little move on Friday of 6% but only about 2 points, it only pushed the Dow down by about 16 points easily made up for by the other 29 stocks in the index. But, a 6% move in the largest NASDAQ stock by market cap will have a dramatic effect on the market cap weighted averages. Oh, you want to hear how that works, too? Here you go...

Market cap weighted indexes like the NASDAQ uses provides a different way to measure price movements. Each stock has a number of outstanding shares and a current price and that's how their market cap is calculated, shares outstanding times price. Then this number is added up and of course that is a huge number so it is normalized with a divisor. In this type of calculation a stock split doesn't affect the index because the market cap does not change if the stock splits.

Using this method gives much more weight to the larger companies in the index but that doesn't have much to do with your mutual fund unless the fund has a weighting of the stocks in the NASDAQ similar to the index's. So, there are problems with either method. But, as we mentioned about an hour ago above, a stock like MSFT has a significant impact on the NASDAQ indexes since the market value move of 6% is larger than many companies' total value.

Just a few comments about the market's potential this week. We are getting more bearish by the day and think the best situation is to get short again. We plan to do that this week and most likely prior to Friday. The best way to look at this is in the NDX, NASDAQ 100. The NDX has come up from around 1670 to 1940 last Thursday or 270 points, or over 15%. That is a solid countertrend move which could go further which is why we are keen observers this week.

Our position gets support from several sources with the most important being sentiment, bullish sentiment that is. Even our new copy of Barron's that came on Saturday shows a Bull sticking his toe into the water, as in "come on in, the water's fine". This type of confidence in the Bull returning gives us our first signs of a possible turn down.

Our biggest problem is that the next move down is going to be a dramatic affair and we don't want to miss it. So far we have seen a good down move from October but the next move down should make that pale in comparison.

What will drive this down move? It is possible that a decrease in oil prices will fuel (yes, we know it's a little weak but the pun was intended) a downdraft in oil stocks which in turn will drag the Dow and the rest of the market down.

Please check out the True Contrarian at the link to the left. He just, finally, updated his site tonight and he says something similar about oil and other commodities.

FSI: 88.82 (not much going on here on Friday)

Oh, yes, more pictures of our grandson, Jackson.

Jackson had a few shots and still had a couple of bandages on his thigh:

Sleeping in his swing is just the ticket:

Comfortable in Grampa's arm:

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