Why the dumb-as-rocks Dow endures
On Tuesday, the cenacle of gnomes that computes the Dow Jones Industrial Average announced that General Electric, the last survivor among the stocks that made up the original DJIA in 1896, was to be dropped from the roster at long last. The Dow is published nowadays by the financial-rating concern Standard & Poor’s, and the decision to change the makeup of the index involves much procedural complexity and legal compliance mumbo-jumbo.
A lot depends on the Dow, and if S&P were ever perceived to be putting a thumb on the scale, it could lose investor confidence in a big hurry, and probably be sued into triple oblivion by most of the solar system. But, then, that is why the Dow has outlasted all the companies that the Dow was originally stitched together from. Which is an interesting phenomenon in itself.
Columns like this one, solemnly marking the complete ship-of-Theseus replacement of the DJIA, will find it impossible to avoid talking about the economic concept of “creative destruction”. Most of the other original index companies are not only gone from the index; they have gone through cycles, usually many cycles, of merger or schism or diversification or rebranding. The Laclede Gas Co. of St. Louis still exists, and is still mostly a gas company. Other than GE, Laclede is the closest thing, among the original entities, to a continuously existing firm that the cigar-chomping plutocrats of 1896 would recognize.
But on the other hand ... Schumpeter’s notion of “creative destruction” is a description of what market forces do to industrial organization and capitalist economies. What you notice about the original Dow Jones Index is that the component companies had names like “The United States Rubber Company” or “The American Tobacco Company.” This is a hint at the structure of the late19th-century American economy: it was dominated by large industrial trusts. Even the name “General Electric” has that authentic Gilded Age sound.
Many of these trusts were broken up, or encouraged to diversify and internationalize, through government action. This is not Schumpeterian “creative destruction” per se: it is, rather, organized economic power being dispersed by political forces. The corporate entities making up the original index are mostly gone, but the lines of business those companies were in remain pretty important, and only one, the U.S. Leather Co., was ever liquidated outright. U.S. Rubber lives on as Michelin’s U.S.-based Uniroyal branch; the American Sugar Refining Co. is still Big Sugar in the modern guise of Domino Foods.
(It should be remembered that GE might always bounce back and return to the Dow roster. A company no less emblematic and all-American than Coca-Cola was added to the index in 1932 — but then fell out of it between 1935 and 1987.)
The secret of the Dow outliving mere corporate identities is in its brute simplicity. The word a statistician might use here is “robustness.” The journalist Charles Dow needed a measure of the health of the U.S. economy that one person, Charles Dow, could calculate at his desk every afternoon with pen and paper. The DJIA is still just the (scaled) mean of the prices of one share of each stock on the list. This description omits some details — Dow components are given different individual coefficients when a stock splits, for example — but not many.
This means, first of all, that it is very hard for the advisers who “own” the DJIA to put that proverbial thumb on the scale. Dropping or adding stocks to the index bundle is really the only decision for them to make, and they go about that conservatively. (GE is being replaced in the index by Walgreens, the drugstore chain — a sort of representative deputy for the health-care sector.)
If financial indices did not exist, and some highly-trained quant invented one in 2018, he would be unlikely to make it a simple average of share prices. Other wellknown stock indices are, at the very least, usually weighted by market capitalization — and this in turn involves more complexity than you might think, because close holdings, dividend flows, and share buybacks are thought to require special handling.
The Dow, in short, is too dumb to exist, and certainly much too dumb to be used by the financial sector as the single most reliedupon thumbnail indicator of a nation’s economic health. And yet it persists as just that. It is not only tamper-proof: it is, like a durable machine, designed with a minimum of statistical moving parts that might threaten its engineering integrity.
Moreover, it has the advantages that finance people can be taught its broad history in one chart; that their own careers come to be defined by its landmarks; and that the leaps and plunges in the historical Dow line up just fine with wars, crises, and other historical events. I am not sure which current Dow Jones stocks will still be listed on the index in another 122 years. The smart number to bet on would be “zero.” But I do know they will have financial news 122 years from now, and I suspect it will still lead off with the Dow.