The Dow Jones Industrial Average is probably one of the oldest indices around. Originally created in the year 1896, it has gone through several iterations since its inception. Given the length of its existence, you would be right to assume that none of the original stocks are currently still in the index. Since our purpose today is to get a better understanding of the dynamics, we won’t jump much into its history, but we do recommend giving it a read if you get the chance. Because of its age it seen its share of ups and downs during global events.
Today, the DJIA comprises of 30 large publicly traded companies. Unlike other indices that usually take a market cap weighted average cost for calculation, the DJIA uses the stock price weighted average cost for assigning a weight to a stock. Because of the way that the value of the components is calculated and its composition, it can be an attractive index for people wishing to focus on blue-chip stocks. People do tend to have mixed opinions on whether it serves as a good indicator of the market. My personal belief is that even if the composition of companies isn’t indicative of the health of the economy because of how outward looking they are, since there are 30 ‘large’ companies, it can be used as a good gauge for market sentiment. People tend to fall back to blue chip stocks when everything else goes sideways.
One thing that we can be sure about is that it isn’t necessarily the best indicator or a proxy for the industrial sector as only a fraction of the companies that currently make up the index can be considered as being industrial. This might not have been the original intention when it was created but its just the way things are today. For example, some of the companies today include Disney, JP Morgan Chase, McDonald’s, Visa and Walgreen. Another downside to this method is the fact that it does not reflect the difference between a $1 change in a cheaper stock vs a $1 change in a more expensive stock.
The DJIA as an indicator of the US economy has another major flaw, several of the companies are very international facing. When the index was created, the industrial companies that formed a part of the index were all focussed on the U.S. and were thus better represented the overall economy and the industrial side of the economy. If you ever turn on a financial news channel, I’m 90% sure that you heard them saying the dow is up or down. As an investor or a trader you should know that because the DOW is represented by only 30 stocks, the direction of the index does not always reflect the direction of the rest of the equity market.
For traders the DJIA is an indicator that be used for their own short-term positioning. This is because the it comprises of 30 blue-chip stocks. Blue chip stocks are usually good indicators of the market sentiment and the direction in which the market might go. In this way we can say that bearish activity in the DJIA may precede bearish activity in the broader market.
I am not a trader myself, so I do recommend that you thoroughly research any trading strategy before implementing it in your own trades. Looking at it from a more macro-economic perspective the DJIA serves as a good tool for conducting trend analysis because it has been around for a significantly longer time than most other indices.
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