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Flaws In Index

John Mauldin, Thoughts from the Frontline weekly newsletter dated 23 Jan 09, pointed out that the divisor for the Dow Jones Industrial Average (DJIA), a price-weighted index is 7,964782, which means that for every dollar an index stocks falls, the DJIA falls 7.964782 points, regardless of the stock’s capitalisation.

The major flaw in a priced-weighted index is that greater weightage is given to higher-priced stocks. For instance, if Microsoft with a price of $17 and a market cap of $156 billion were to crash to zero, the DJIA would only lose 135 points (17x7.964782). But if the same were to happen to IBM with a smaller market cap of $124 billion at a higher share price of $92, it would cost the index to lose a whopping 700 points!

An alternative to price-weighted index is market-cap weights. STI and S&P 500 are examples of market-cap weights index. But price-weighted also has its drawbacks. To illustrate, on 29 Jan 2009, STI rose 0.64 of a point to 1,7766.72, a move that a casual observer might interpret to indicate a mixed or quiet session. However, if one were to exclude warrants, the rest of the market only recorded 95 rises against 188 falls, a gain/loss ratio that indicated market weakness rather than a mixed session. On 29 Dec 2008, a sudden 87% surge by CapitalMall Trust in the final minute of trading helped push the STI up 54 points, creating the mistaken impression of a session that was much stronger than it really was.

As we can see, both may give rise to ‘wrong signals’ in the market. The different is the magnitude of the ‘wrong signals’. Hence, between market-cap weights and price-weights index, market-cap weights is probably a better way to capture what’s going in a stock market, at least for most of the time and over longer time periods.

R Sivanithy, Business Times dated 2 Feb 2009 pointed out this might be the reason (flaw in the DJIA) why DJIA is seen to be pondering at 8,000. Afterall, most of the news on Wall Street these days centres on the crippled financial and auto sectors. But because the share prices of these companies are now so low, these stocks do not affect the DJIA by much. That is, because the index stocks most affected by bad news are already battered to rock-bottom levels, the DJIA doesn’t seem to fall much when news is released, thus giving the mistaken impression of resilience to adverse news and of strong support around 8,000 points.