Today I've invited Don Heggan from Dynamic Stock Market Strategies to discuss his insiders knowledge on what's really behind the DOW. Please take time and read the post and comment for Don to discuss.
If you’re a trader and you don't know what’s going on inside the Dow, you don't know anything worth knowing. Learn to penetrate the smoke screen that the Dow-Jones Industrial Average has become.
The complex formula used to compute this monstrosity, called price-weighting, goes far beyond simply adding up the individual prices and dividing the whole thing by thirty. It, instead, employs a divisor designed to compensate for dividends and stock splits.
The effect of all this not only gives the higher priced issues more weight in the average but accounts for the incredibly high valuation of the average itself. Confused? Good! You're supposed to be. You see, dividing a number by a value less than one actually turns it into a multiplier!
The current divisor, as of this writing, is approximately (are you ready for this???) 0.122834016 which is the same thing as multiplying by 8!
That means a one point move in a stock is good for an eight point move in the average.
It also allows a few higher priced issues to give the illusion that the average stock is moving up when, in fact, the majority are moving down.
Imagine thirty men carrying a heavy load up a mountain. In the beginning all is well; each member is bearing their fair share of the load. As the climb continues, visualize one member at a time becoming exhausted and, unable to continue, dropping out. This means the heavy load, shouldered by a constantly shrinking number of remaining members of the climb, eventually collapses under its own weight.
If you were keeping track of the climbs' progress and noted that what started out as a 30 man team was now down to fewer than 15, what would be your prognosis?
What would be your prognosis if all you saw was the average moving higher and higher and were completely unaware of what was going on inside?
Inside the Dow: Ignore it at your peril.