Learning to penetrate the smoke screen that the Dow-Jones Industrial Average has become is, in my opinion, vital to the success of any investor or trader. If you don't know what is going on inside the "Dow", you don't know anything worth knowing. The complex formula used to compute this monstrosity, called price-weighting, goes far beyond simply adding up the individual prices and dividing the whole thing by thirty. It also employs a divisor designed to compensate for stock splits. The effect of all this not only gives the higher priced issues more weight in the average but accounts for the incredibly high valuation of the average itself. Confused? Good! You're supposed to be. You see, dividing a number by a value less than one actually turns it into a multiplier! The current divisor, as of this writing, is approximately .2 which is the same thing as multiplying by 5! That means a one point move in a stock is good for a five point move in the average. It also allows a few higher priced issues to give the illusion that the average stock is moving up when, in fact, the other issues are moving down. Imagine thirty men carrying a heavy load up a mountain. In the beginning all is well; each member is bearing their fair share of the load. As the climb continues, visualize one member at a time becoming exhausted and, unable to continue, dropping out. This means the heavy load, shouldered by a constantly shrinking number of remaining members of the climb, eventually collapses under its own weight. If you were keeping track of the climbs' progress and noted that what started out as a 30 man team was now down to fewer than 15, what would be your prognosis? What would be your prognosis if all you saw was the average moving higher and higher and were completely unaware of what was going on inside? What's going on inside the Dow? Those that know should have a better chance of profiting than those that do not. |
