Money: Down on the Dow

As always, the venerable Dow Jones Industrial Average has been the public's market barometer during the recent record-breaking Wall Street rally. But how good an indicator of stock trends is it, really?

The Dow hasn't come by its high profile by chance. After all, the index has been calculated and published for nearly 54 years. But can an index of just 30 industrial giants really tell the full tale of the tape?

For instance, while the Dow was skyrocketing 14.7 percent from its August 13 low of 777 to 891.17 on August 23, other market indices were lagging behind. The American Stock Exchange's 900 stocks advanced 10.2 percent over the same period. The over-the-counter market's 3000-issue NASDAQ index rose only 6.74 percent. The Standard & Poor's 500 index came closest, rising 11.8 percent. Conversely, on August 24, while the "blue chip" stocks that make up the Dow fell 16.27 points, smaller-company shares on the over-the-counter market and the Amex rose 2½ and 3½ points, respectively.

With such discrepancies, many analysts are calling the Dow misleading, if not obsolete. They note that until recently the last major change in the index came in June 1979.

"As far as I'm concerned it's useless," Herbert Saturn, Washington assistant manager of Drexel, Burnham, Lambert told me. "A perfect example is August 24. The Dow was down 16 points, and yet advances led declines 960 to 700. Ridiculous." He said many investors were calling to inquire why their stock languished while the Dow soared.

The Dow "is not nearly as good an indicator as the Standard & Poor's 500," maintains Washington financial adviser Barry Goodman. "It includes a heck of a lot more stocks and is a better indicator of the market in general."

But the Dow has its defenders. Monty Gordon, research director for Dreyfus Securities in New York, agrees that the S&P 500 is "a better indicator of what the broad market is doing." And he concedes the Dow is too limited at a time when "the market and the economy itself have gotten so much larger and more diverse."

But then Gordon ticked off a list of positives. Because of its "historical perspective," he noted, "the Dow is so identified with the market" that the "whole structure of technical analysis has grown up around it." Moreover, added Gordon, it includes "the leaders in different industries" that are "cyclically responsive" and "give a broader perspective on the market." Although its components were the focus of a heavy institutional buying panic in the third week of August, the Dow was "a pretty good indicator in that the market moved up broadly," Gordon contended.

No market average is perfect, argues Charles Stabler, assistant managing editor of Dow Jones's Wall Street Journal. "If a lake is an average three feet deep, it can be deeper than that in some places." In the long run, said Stabler in an interview, the Dow and other indices "really don't diverge." True, he said, second-tier stocks have lagged behind, but "it's perfectly reasonable" to expect that they'll catch up "when the move in the big capitalization stocks runs out."

Stabler also defended the Dow from the frequent criticism that it includes a utility, AT&T. "Although it's a large utility, it's also a large manufacturer through its Western Electric subsidiary. It also performs more like an industrial than a utility."

Asked if Dow-Jones is contemplating any future changes in its index's composition, Stabler said in late August, "We're constantly looking at it, but nothing is contemplated now." A few days later, a bankrupt Manville company was excised.

No investor should "use the Dow alone," stressed Gordon, but as far as public perception is concerned, "the Dow as a surrogate for the market is not a misplaced confidence. If an individual is looking for some idea of what the market is doing, the Dow is a reliable indicator."

On October 1, four futures exchanges began trading options on commodity futures contracts (see my October column) for the first time since 1936. So far, investors can buy or sell options contracts in gold, sugar, and Treasury bills.

Unfortunately, after interminable bureaucratic delay, this "pilot program" of commodity options may not get a fair trial. Because the Commodity Futures Trading Commission (CFTC) has forced the exchanges to impose high margins on the writers (sellers) of options, there is concern in many quarters that options will not achieve sufficient volume to have a chance at success.

Although option buyers pay only a fixed premium for the right to buy or sell at a certain "strike price," option sellers face futures-like risks and must post margin equal to their premium income plus the usual margin on the underlying futures contract. This steep margin could dissuade many option writers from selling options at a reasonable price and discourage many investors from buying them.

Not so, says James Day, who heads the options department of Chicago-based Heinold Commodities. He predicts that despite the CFTC's "onerous and illogical" margin rules, options will be "in such demand that (commodity) markets will explode like never before." He says 20 million people who now trade options on stocks will be potential commodity option customers—particularly when stock futures options become available. "The benefit of knowing your risk in advance is a powerful drawing card," says Day.

Steve Beckner is a financial reporter and columnist for the Washington Times and the author of The Hard Money Book.