Upon speaking with many traders and investors over the years, I found it rather surprising how many of them had almost no clue how the Dow Jones Industrial Average ($INDU) really works, or even less how it is calculated.  If you want to succeed, you better know the subtle rules and intricacies of the games you’re playing.  Understanding how an index as critical as the DOW is calculated would certainly fall into that category.  Ironically, it is so shockingly simplistic, you will like have an “aha” moment as you understand why (besides inflation), the DJIA tends to exhibit such a strong upward bias.

While most broadly followed market indices today are “cap-weighted”, such as the S&P 500, the Nasdaq, and the Wilshire, the DOW is a “price-weighted” index (as are all of the DOW indices).  In a “cap-weighted” index, large price moves in the largest components have a much more dramatic effect on the value of the index.  So, if you have a company such as Apple that now has a market cap north of $300 Billion, you can see how much greater an effect that one company can have on an index over many other components.  However, you can make a point that such size brings clout, huge liquidity, and a huge shareholder base, so this potentially justifies its extra weight.

Regardless of any criticism you may have on the “cap-weighted” approach, the “price-weighted” method used to calculate the DOW will leave you with even more room for question.  Equal importance is placed on all stocks in the index, with each company’s stock price adjusted by a divisor, then added together.  The net effect of this is that share price alone becomes the most important criteria for maximum effect on the value of a “price-weighted” index!  For example, if you have a $10 Million company trading at $200/share, and a $100 Billion company trading at $20/share, the $10 million company will effect 90% of the value of the index, and an equal move in the $100 Billion company will effect a mere 10% of the index value.

The DJIA divisor is updated periodically and adjusted to offset the effect of stock splits, bonus issues, dividend payouts, or any changes in the companies that form the index.  When the DOW was originally created back in 1896, there were only 12 initial components that were simply divided by 12.  In 1928, the number of stocks was raised to 30.  Now, let’s say that our most expensive stock is currently trading at $100 and it has a 2:1 split to $50/share and causes the index to drop by 10%.  The divisor is used to readjust the index to its pre-split level.  This is all well and good, except for the fact that all these changes over the years have reduced the divisor to miniscule levels that now have a HUGE multiplier effect.  This dramatically increases the overall volatility of the index, especially with a large price move in a high-priced component.

For example, in June, 2009, General Motors and Citigroup were removed from the index, and Cisco and Travelers took their place.  With so many splits and changes over the years, the current divisor value is now a tiny 0.132129493.  In layman’s terms, for every $1 change in the price of a stock in the average, you can expect to see a 7.57 point change in the DJIA index (1 / 0.132129493).  So take a moment to think about this in terms of the 30 DOW stocks.  Most of the movement you see on a daily basis is caused by the top few highest price stocks, which currently include IBM (leading way ahead at $175/share), followed by CAT (at $107/share), and then CVX (at $105/share).  Bank of America is at the bottom of the list at around $10.50/share.

Now think how much easier it is to get a $1 price move on a $100 stock versus a $10 stock, and it’s pretty easy to see how index volatility can explode when a high-priced component exhibits a large change in price.  In addition, the more component stock prices increase, the more volatile the index becomes, and the greater the likelihood we will routinely see moves that average several hundred points a day.

You may have figured that with this technique, the DOW also seems inherently rigged to continually move higher.  For those pundits who’ve called for DOW 1,000 again and again, take a moment to think about this possibility.  Besides the obvious effects of inflation, how could that really ever happen?  Every time a few stocks in the index fall heavily out of favor (or are on the verge of bankruptcy), they are replaced with much more solid companies, trading with much higher stock prices, and generally at a time when the market has already experienced a large correction.  In fact, had you simply bought the DOW after the component-change announcement was made in June 2009 (or even better, a few of its highest price components), you would have fared quite well in the market since then.

Martin Armstrong is the author of the Economic Confidence Model based on an 8.6 year business cycle theory inspired by the work of Nikolai Kondratieff.  Two years ago, the cycle once again accurately predicted the peak of the last economic cycle years in advance.  February 26, 2007 yielded some of the tightest credit spreads ever (easy access to credit), and the housing market had already begun its sharp decline.

He is currently in prison, indicted in 1999 on charges of defrauding Japanese investors.  His trial would have made more sense had it taken place in “Alice in Wonderland”.  Without getting into all the details here, just the fact that he was in jail for seven years for contempt of court should be enough to make any American cringe and wonder how that’s possible in the great ‘ole USA.  He finally caved in and plead guilty in 2007 to the fraud charge.  In return, he was given an additional five year prison term in addition to the seven he had already served!  Now, if this were any ordinary American schmo, perhaps he could be written off for one reason or another as just another guy with a crazy “they’re out to get me” sob story.  However, when you look deeper into the facts, and then consider that Mr. Armstrong was also one of the most respected financial research advisers to scores of powerful figures from central bank executives to heads of multinational corporations to heads of state, it really makes you wonder what’s going on with the “Rule of Law” — the real glue that holds our country together.  Armstrong even authored the most insightful and thorough analysis of the 1929 crash ever assembled on behalf of the Reagan administration in the ’80s.

From his jail cell, Martin Armstrong continues to write some of the most insightful and interesting essays I’ve come across on a variety of topics from market cycles, to rule of law, to the history and cycles of politics and war.  Since he has access to little more than an old typewriter (and no whiteout), you must understandably have a bit of patience with his “what I’m thinking about now” writing style.  Would I be showing my age if I can still recall the nightmare of using a typewriter for school papers?  It’s horrible.

Regardless, I’ve learned more useful knowledge about world history (and our own history) from Armstrong’s essays than I ever learned in school.  And it’s more fascinating than you can even imagine.  Everything’s been done and tried before.  And here’s some food for thought…  in the six thousand or so years of civilized history, can anyone find one example where socialism actually succeeded with a happy ending?  But I guess that’s why most politicians don’t bother to learn any of history’s lessons.  It would just interfere with their agendas and other questionable motives.

The following text is an excerpt from Martin Armstrong’s latest essay entitled “Objective vs Subjective Analysis” (pages 10-12).  I’ve also taken the liberty of making some small corrections here and there to make the text more readable while still hopefully maintaining Mr. Armstrong’s full meaning and intent.

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