Often the Dow Average will provide a good forecast for the overall market as you can fairly quickly analyze the 30 stock charts involved. It also helps to understand how INDU is computed and the multiplier
effect in its computation.
One thing to know is that, because the Dow 30 (INDU) measures all net changes in the same way, the effect is an actual price weighting system that results in the HIGHER priced stocks accounting for more of a change in INDU. The Dow is still the hold-out price based average; it is called an 'average' rather than an index, which are capitalization weighted; hence moves in bigger companies' stocks count for a bigger change in the index price. 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, further on.
On the practical monitoring side, I have the 30 INDU stocks set up on 5 pages, with 6 stocks in their own windows per 'page'. In my TradeStation application, these pages are called workspaces and by other terms in other charting applications. It's fairly easy and quick to flip through my 5 workspaces and to spot the charts that are bullish, bearish or having a sideways 'neutral' trend pattern. If there are 10 stocks that look quite bullish, 10 that are more or less neutral and 10 that are lagging somewhat in an overall up trend, it's easy to forecast more upside ahead as the gains in the 10 bullish leaders will pull the Dow higher. If the 10 stocks in strong bullish trends have half that are high-priced stocks (e.g., Boeing or 3M), I figure I can go into, or safely hang on to, Dow Index (DJX) calls.
You just can't easily and quickly do a 'bottoms up' individual stock chart analysis in the S&P 100, 500, or the Nasdaq 100 or Composite.
In my most recent Trader's Corner column (Sat, 7/31) I said the following regarding the prospects for further gains in the Dow: "A number of key Dow stocks look like they're consolidating for a push higher. This coming week should give us more to go on in terms of how AXP, BA, CAT, CVX, DD, GE, JPM, KO, and UTX fare. All these stocks look to be consolidating for a next push higher."
Here is what these 9 charts looked like after 3 more days of market action (after the prior week's close). Of the 9 stocks I mentioned, more than half of them were trading at $50 and above; 4 were above $70. Compared to stocks like GE, Microsoft, Intel and Cisco, all trading in the 20-$30 range or less, bullishness implied in the stock charts I singled out were going to 'weigh' more in sending the Dow significantly higher. A current Dow chart then follows my next 2 composite charts.
3 of the 4 stocks shown in this first chart had formed bullish flag patterns, a type of recent sideways consolidation that suggests a next move higher.
All 5 of the stocks shown in my next composite chart also had bullish 'flag' type patterns through the past week, with the predicted result of a next move higher as seen THIS week.
Of all the major indexes, the daily Dow 30 chart (seen next) best showed the bullish falling wedge pattern and the subsequent upside breakout above the upper end of the wedge.
The weekly INDU chart is seen next to show the larger picture. The speculation by a number of pundits (not me) had been that the Dow (and S&P) had formed a huge Head & Shoulder's top , but this interpretation has now been 'negated' by the upside breakout above the down trendline related to the 3rd top (the Right Shoulder).
THE DOW AVERAGES - A LITTLE 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 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, rounded to the nearest 1/8th, from the price of the stock.
For example, if General Electric was trading at $50 and was scheduled to pay a $1 quarterly dividend on June 1st, General Electric would trade ex-dividend on June 2nd at only $49 a share and shareholders of General Electric 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 fractional movement in the price of the component 30 INDU stocks (say up or down by half a point) results in relatively large movements in the Dow; e.g., a 1/2-point increase in each stock might translate into a 45-point move in INDU.
As a result of the way the Dow is computed, the Average has effectively become a price-weighted measure of the market. The Divisor simply measures the sum of the day's changes and there is nothing in the formula to account for the fact that a $1 change in a $15 stock is, percentage-wise, greater than a $1 change in a $100 stock.
A $1 move up or down in a $100 stock is only a 1% move, a commonplace event, whereas a $1 change in a $20 stock is a 5% move which is rarer. The Divisor does not correct for the relative magnitudes of changes between differently priced stocks so higher priced stocks, as I noted in the beginning of this article, influence the Dow to a greater degree. Although 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, it does help better understand the daily movements in the Dow.
THE DOW 'MULTIPLIER':
The current value of the Dow Divisor is 0.132129493 (as of August 1, 2010) 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 7.57 (1/0.132129493) change in INDU. The present divisor, after many adjustments, is less than 1, meaning the index is actually LARGER than the sum of the prices of the components. The foregoing explains why the average can be reported as, for example, 10,000, even though the sum of all 30 stock prices is nowhere close to that number, unlike when Charles Dow first devised his Average.
GOOD TRADING SUCCESS!