MAILBAG QUESTION:

"good day leigh. would you be kind enough to send me the new dow jones multiplier. before addition of GS, etc the old was 7.96 i think . the new is ??? thanks and regards."

MY RESPONSE:

The new multiplier for the Dow 30 (INDU) is 6.42 after the addition of Goldman Sachs (GS), Nike (NKE) and Visa (V), which recently replaced Alcoa (AA), Bank of America (BAC) and Hewlett Packard (HPQ) in the INDU Average.

To compute the INDU 'multiplier', you need to know the value of the Dow Jones Divisor, which is currently 0.15571590501117. I'll explain why what used to a number you would divide by (a divisor) has 'become' a number that you use to multiply by.

The simple answer of how you use the current 6.42 INDU multiplier is this: Every $1 change, up or down, in price in a stock within the Dow Average currently results in a 6.42 (1/0.15571590501117) change in INDU. If 25 of the 30 Dow stocks were unchanged and 5 were each up a buck (I know, impossible - but a simple example!), the Dow Average would be up 5 X 6.42 or 32 points.

The first thing you have to know about the Dow Jones Industrial Average (INDU) is that, because the Dow 30 (INDU) measures all net changes in an equal way, the effect is an actual price weighting system that results in the HIGHER priced stocks accounting for more of a change in INDU than the LOWER priced stocks in the Dow.

A $200 dollar stock (e.g., Visa) is much more likely to be up or down 3-4 dollars or more in day than a $23 dollar stock (e.g., CSCO). Therefore, 'normal' fluctuations in Visa's (V) stock value, accounts for larger point changes in the Dow. If V gains $8, just a relatively small percentage (4%) change for the stock, the Dow will gain 51 points (8 X 6.42).

The Dow is still the hold-out price based average; EACH dollar change (1 X 6.42) in ANY of the 30 stocks, accounts for an EQUAL change in the Dow Average.

All the Stock Indexes such as the S&P 500, the Nasdaq Composite (COMP), etc. are capitalization weighted; i.e., moves in the stocks with the largest capitalization (number of shares X the share price = total capitalization) count for a bigger change in the index price. The total value of stock with an enormous value (e.g., Exxon) accounts for a larger percentage change in SPX than a company with a smaller total dollar value (capitalization). A $3 dollar change in XOM (Exxon) accounts for a greater percent gain or loss in the SPX Index than a $3 change in Pfizer (PFE).

Nevertheless, there is a certain type of 'weighting' in the Dow Average in that the higher priced stocks add more to the Dow's gains or losses from day to day. More on the computation of the Dow and why the current 'divisor' is now a multiplier.

THE DOW AVERAGES - SOME HISTORY:

There are currently 30 stocks in the Dow Jones Industrial Average (INDU), 20 in the Dow Jones Transportation Average (TRAN), and 15 in the Dow Utility Average. A comparison of the Transports and Industrials is the basis of the so-called Dow Theory.

The Dow Jones Industrial Average started with only 12 stocks in the late 1800's and grew to its current 30-stock roster in big jumps. In 1916 the average expanded from 12 to 20 stocks and in 1928 an additional 10 stocks were added. Although it is easy to find out what companies are currently in the various Dow Averages, the actual mechanics for computing the Averages tends not to be well known.

When Dow created his first Average of 11 Railroad stocks (which would today be part of TRAN) he simply divided the total of all the prices by 11 to get his result. Living in the days before frequent stock splits and stock dividends, Dow did not foresee events that would make the divisor change. As markets matured and companies began to try to keep the price of their shares within certain parameters, stock splits became a common tool to keep the price per share at a reasonable level.

Until the implementation of the Dow Divisor, Dow Jones & Co would account for any splits by multiplying the stock price by the number of shares into which each share was split. Unless they did this, a 2 for 1 split for example in a Dow stock would have caused a significant drop in the Average that was not the result of any fundamental change. For example, if General Electric split 2-for-1 in the past, Dow Jones editors would multiply the current price of GE by 2 before figuring out what the Dow had closed at for the day.

With this method, the Average reflected the results of what a simple buy and hold strategy would have attained and effectively neutralizing the effects of stock splits. However, stocks that split their shares numerous times would come to have more and more effect over the daily moves of the Dow, because their small daily movements would be multiplied to account for numerous splits. This distorted the Average by making it 'split-weighted', allowing companies who split their shares more frequently to have a disproportionate effect on INDU. To correct this, the editors at Dow Jones & Co, a company I used to work for, developed the Dow Divisor, a single number that took into account the splits for each individual stock.

Dow Jones & Co, now owned by Rupert Murdock's flagship company, currently adjusts the Dow Divisor if any event affects the Dow Industrial Average by 5.0 or more points. Stock splits are not the only factor that affects INDU and another is stock dividends. When a stock pays a dividend, the NYSE specialist firm who facilitates trades in the stock at the NYSE (there are now also a few Nasdaq traded stocks in the Dow) deducts the amount of the dividend from the price of the stock.

For example, if JP Morgan Chase & Co (JPM) was trading at $50 and was scheduled to pay a $1 dividend on June 1st, JPM would trade ex-dividend on June 2nd at only $49 a share and shareholders of JP Morgan Chase would have the stock ($49) and the dividend ($1), for a total of $50 worth of stock and dividends. Large 1-time cash or stock dividends and spin-offs of subsidiaries can move the Average a lot more than 5.0 points, so the Divisor is also adjusted to compensate for all of this.

The divisor approach worked well for the first few decades but in recent decades the Divisor has become very small. In 1986, the Dow Divisor fell below 1.0 for the first time, effectively becoming the 'Dow Multiplier' since to divide by a fraction, we invert it and multiply, resulting in a larger number; if the Dow Divisor were at 0.333, the prices of the stocks on the Average would be tripled when the Dow is computed. This creates a situation where even a small movement in the price of the component 30 INDU stocks (say up or down by a dollar) results in relatively large movements in the Dow; e.g., a $1 increase in each of the 30 Dow stocks currently would translate into a 193 (30 X 6.42 = 192.6) point gain in INDU.

As a result of the way the Dow is computed, the Average has effectively become a price-weighted measure of the market. There is nothing in the formula to account for the fact that a $1 change in a $30 stock is, percentage-wise, greater than a $1 change in a $100 stock. And there is nothing to suggest that most of a daily Dow price change occurred in say just 3 of the largest dollar value stocks; e.g., VISA, IBM, GS.

A $1 move up or down in a $100 stock is only a 1% move, a commonplace event, whereas a $1 change in a $25 stock is a 4% change in price which is rarer. The Divisor does not correct for the relative magnitudes of changes between differently priced stocks so higher priced stocks, as already noted, influence the Dow to a larger degree. This discussion may raise the question of whether the Index is truly representative of the New York Stock Exchange which was Dow's original intent, or the broader market which is how the media treats it, but it does help better understand the daily movements in the Dow.

THE DOW 'MULTIPLIER':

The current value of the Dow divisor is 0.15571590501117 (as of 9/30/13) and this figure which gets adjusted slightly every so often, is reported in the Wall Street Journal. Every $1 change in price in a stock within the Dow Average currently results in a 6.42 (1/0.15571590501117) change in INDU and 6.42 is the current Dow Jones multiplier. The present divisor, after many adjustments, is far less than 1, meaning the index is actually significantly LARGER than the sum of the prices of the components. This explains why the average can be reported as, for example, 15,000, even though the sum of all 30 stock prices is not close to that number, unlike when Charles Dow first devised his Average.


GOOD TRADING SUCCESS!