Dow 20,000 – an incredible milestone! The Dow Jones industrial average is nearing the 20,000 mark for the first time, and when the barrier is broken, Americans watching the evening news, tuning in to the radio or aimlessly browsing the internet will see the headline, whether they care about it or not.
Should investors really care? Should anyone? And the answer is: yes and no.
Regardless of what importance level you assign to Dow 20,000, here are five things everyone should know about Dow 20k.
1. The Economy is Improving and so are Expectations
This one may be obvious, but with the Dow and other stock market indices at all-time highs, things are getting better. Over the last 81 months the private sector has added an impressive 15.6 million jobs, and in November the unemployment rate hit 4.6 percent for the first time since August 2007.
On top of that, when the Federal Reserve raised interest rates interest rates on Dec. 14, Chair Janet Yellen said the hike was “a reflection of the confidence we have in the progress the economy has made and our judgment that progress will continue … the economy has proven to be remarkably resilient.”
Consumer confidence also improved in November, reaching pre-recession levels once again. As expectations improve, you can generally expect to see the stock market rise as well.
2. The Dow Actually Isn’t a Great Reflection of the Business Landscape
If the first point was a little straightforward, this one may be the most misunderstood: The Dow is definitely not the best measure of how American businesses are performing. That 20,000 figure? That’s only based on the share prices of 30 of the largest companies in the U.S.
“The Dow represents 30 large stocks. The S&P 500 represents nearly 17 times that number,” says Kevin Barr, head of investment management at SEI, an investment management firm headquartered in Oaks, Pennsylvania. “Both the Dow and S&P leave out the mid- and small-cap companies that form much of the stock market, which comprises thousands of stocks. While the Dow is commonly cited as a benchmark, investors need to keep its size and scope in mind.”
On top of that, the Dow is a price-weighted average, which means that stocks with higher share prices carry more influence. Nevermind that this is an entirely arbitrary way to do things. Currently, Goldman Sachs Group (GS) carries the heaviest weight in the blue-chip index at 8.38 percent, while Cisco Systems (CSCO) has the lowest weight at 1.06 percent.
Thus, if CSCO jumps 10 percent after a great earnings report, but GS falls just 1.3 percent, the two cancel each other out as far as the Dow is concerned. This despite the fact that at $153 billion, Cisco is actually worth about $56 billion more than Goldman Sachs.
While the S&P 500 is a better measure of how corporate America is doing, a better measure still is the Russell 3000 and Wilshire 5000, which track thousands of smaller stocks and represent essentially the entire U.S. stock market.
Unlike the Dow, the S&P 500, Russell 3000 and Wilshire 5000 are all market capitalization-weighted.
3. Put Dow 20,000 in Perspective
Due to the power of compound interest, 100-point – or even 1,000-point – swings in the Dow don’t mean what they used to.
Think about it this way: The Dow first crossed the 1,000 mark in November 1972. It would take more than 14 years for the Dow to gain the next 1,000 points, which it accomplished when it first broke 2,000 in 1987. In contrast, the Dow hit 19,000 on Nov. 22, and is approaching 20,000 less than a month later.
So if you hear that the Dow went up or down 100 points in a day, don’t put too much stock into it. In 1972, that was a 10 percent move. Today, it’s a half-percent.
4. A Few Minor Changes in the Index’s Constituents Make a Huge Difference
Further adding to the arbitrary nature of the Dow, the index’s 30 constituents aren’t set in stone like many people might think.
Every few years or so, if it’s necessary, the index committee will add some new member(s) to the index; the incoming stocks will often replace stocks or companies that have been faring poorly or are losing influence.
Sometimes, those decisions can seriously hamper the index’s returns.
The Dow, for instance, added Intel Corp. (INTC) and Microsoft Corp. (MSFT) in late 1999, near the height of the dot-com bubble, only to see both crater over the subsequent year. It would take until 2014 for MSFT and INTC to regain their debut Dow levels.
The most recent Dow addition is Apple (AAPL), which replaced AT&T (T) in March of 2015. Since then, Apple is down 6 percent and AT&T shares are up 24 percent.
David Blitzer, managing director and chairman of the index committee at S&P Dow Jones Indices, says companies aren’t added to the index because their stock looks attractive. “We’re not picking stocks that we think are definitely going to go up. I know one guy who can’t pick stocks, and that’s me,” Blitzer says.
“With the Dow we’re looking for large, solid, stable companies,” he says. “Most of them if not all of them are household names, people know who they are, and it’s traditionally blue-chip companies.”
5. Just a Psychological Level
Finally: traders just like to see big, round numbers with lots of zeros after them, and investors do too. Crossing a level like Dow 20,000 has no fundamental importance, but technical and short-term traders, as well as trading algorithms, may put some stock in it.
Over time, we’ll be hitting a lot of these psychological marks, says Jon Ulin, a certified financial planner and managing principal of Ulin & Co. Wealth Management, a branch office of LPL Financial in Boca Raton, Florida.
“Since World War II, the Dow Jones index has averaged about 9 percent per year and will continue to do so hitting new highs over time. Just with a meager 7.2 percent annualized return, we should be ringing in a 40,000 Dow by 2027,” Ulin says.
It’s been 44 years since the Dow first hit 1,000 in 1972. If it takes 44 years for the next Dow 20-bagger, we’ll be ringing in Dow 400,000 in 2060 (which will be another election year).
Written by John Divine of U.S. News & World Report
Source: U.S. News & World Report