Wow, how have times changed.  The Dow Jones Industrial Average, or The DOW as it is often referred to, made its debut on May 26, 1896.  Back then, it consisted of twelve little comapnies who would shape the industrial revolution of this country.  Twelve years before its debut, Mr. Dow published his index in the Customer’s Afternoon Letter, which would later become known as the Wall Street Journal, which is still published today 6 times a week.  Of those twelve original companies, only General Electric still remains on the index.  When the index was first published, it stood at 40.94.

Over those 112 years, companies have been added and removed from the index to ensure that the largest and most widely held stocks were the DNA of the index.  For example:

• American Insurance Group (AIG) was added to the index on April 8, 2004 replacing AT&T.
• Bank of America, one of the US’s largest financial institutions was added to the inndex on February 19, 2008 replacing Altria Group, Inc.
• Just 54 months later, narrowing escaping a collapse, Kraft Foods replaced AIG on the index on September 22, 2008.

How is The DOW Calculated?

To calculate the DJIA, the sum of the prices of all 30 stocks is divided by whats known as the DJIA divisor. Adjustments are made to the divisor in case of stock splits, divestitures or other similar structureal changes member firms may go though.  These adjustments to the divisor are made to ensure that such events do not alter the numerical value of the DJIA. initially, the divisor was the number of firms on the index, so the original DJIA was at first a simple arithmetic average.  Due to the many adjustments that have been made over time, the present divisor is less than one.  In effect, this means that the index is actually larger than the sum of the prices of the components. That is:

where p are the prices of the component stocks and d is the Dow Divisor.

Certain stock related events, such as stock splits,  or modifications made to the list of the companies composing the index alter the sum of the component prices. In these cases, in order to avoid skewing the index, the Dow divisor is updated so that the quotations right before and after the event coincide:

The DOW 30

As of this blog posting, the following companys are listed on the The DOW:

3M Company, Alcoa Incorporated, American Express Company, AT&T Incorporated, Bank of America Corporation, Boeing Corporation, Caterpillar Incorporated, Chevron Corporation, Citigroup Incorporated, Coca-Cola Company, DuPont, Exxon Mobil Corporation, General Electric Company, General Motors Corporation, Hewlett-Packard Company, Home Depot Incorporated, Intel Corporation, International Business Machines, Johnson & Johnson, J.P. Morgan Chase & Company, Kraft Foods Inc., McDonald’s Corporation, Merck & Company, Incorporated, Microsoft Corporation, Pfizer Incorporated, Procter & Gamble Company, United Technologies, Verizon Company, Wal-Mart Stores Incorporated, Walt Disney Company

Does The Dow really matter?

On Wednesday, November 19, The Dow closed below 8000 for the first time since 2003.  In markets that are already on edge, the psychological effect of breaking through this level can go both ways.  Some investors may begin to think we are hitting som arbitray floor and some investors may take this as meaning the sky is falling.  So to inject some rationale in an irrational market,  Companies’ earning prospects are still better today than they were back in 2003, no matter how dire short term profit predictions appear to be.

Most people you talk to have really no idea of what The Dow is realling measuring (hence the short discussion above).  It is a psychological issue at this point.  The Amercian public knows that not to long ago (October 9 2007) that the DOW hit its all time  high of 14,164.53 and now they see it in the 8000s, the perception is that things are dire.  Don’t get me wrong; the economy could be doing a lot better at this point, but it also could be doing a whole lot worse.  In fact, the general state of the economy will most likely continue to diterirater over the next several quarters.  Some economists predict that the economy will continue to shed 100,000 jobs a month until the Summer of 2009.  These are bleak predictions in deed, but it is not the end of the world.

The Dow is one of many important indicators as to the overall health and stability of the US Economy, and for that matter, Global Economy.  By no means is it the defacto standard that it one was.  Too many times you hear people pontificate that The DOW will reach 0.  That is just almost statistically impossible based on how the index is calculated.  Granted, times are tough and are going to remain tough for the foreseable future, but the US and other countries around the world will come out of this.  Hopefully we will emerge from the current turmoil with the knowledge and insight to not let this sort of global financial meltdown occur again.