Saturday, 23 June 2012

Dow Jones History — Tracing the Origins of this Popular Index

Before we start tracing the Dow Jones history let's first understand what exactly the Dow Jones is. Next, we'll take a look at how the Dow has performed since it first started. Finally, we'll conclude with understanding how the index is actually calculated.

What Exactly is the Dow Jones?
The Dow Jones Industrial Average (DJIA), more commonly known as theDow, is a stock market index created by Charles Dow and Edward Jones way back in 1896. Today, the Dow Jones & Company owns this index.  Dow Jones & Company is in the publishing and financial information business. Among other publications, they own the Wall Street Journal and Barron's weekly magazine.

Today, the DJIA is made up of 30 large, publicly owned companies based in the United States. The index reflects how the stock price of these 30 companies perform during the trading day.

Dow Jones History

The Early years
Charles Dow, a journalist, and his partner, Edward Jones, a statistician, founded the Dow on May 26, 1896. About twelve years earlier, Charles Dow had created the Dow Jones Transportation Average, consisting entirely of railroad stocks. At that time, the railroad industry was the main industry in the United States.

However, Dow realized that industrial stocks were becoming a small but growing part of the market. This drove the creation of the DJIA.

There were a total of 12 companies in the original index. As listed byWikipedia, these are:
  1. American Cotton Oil Company ... now part of Unilever.

  2. American Sugar Company ... now Domino Foods, Inc.

  3. American Tobacco Company ... broken up in a 1911 antitrust case.

  4. Chicago Gas Company ... now an operating subsidiary of Integrys Energy Group.

  5. Distilling & Cattle Feeding Company ... now Millennium Chemicals.

  6. Laclede Gas Company ... still in operation as the Laclede Group, Inc., but removed from the Dow Jones Industrial Average in 1899.

  7. National Lead Company ... now NL Industries, removed from the Dow Jones Industrial Average in 1916.

  8. North American Company ... broken up by the U.S. Securities and Exchange Commission (SEC) in 1946.

  9. Tennessee Coal, Iron and Railroad Company ... bought by U.S. Steel in 1907. U.S. Steel was removed from the Dow Jones Industrial Average in 1991.

  10. U.S. Leather Company ... dissolved in 1952.

  11. United States Rubber Company ... changed its name to Uniroyal in 1961, merged with private B.F. Goodrich in 1986, bought by Michelin in 1990.

  12. General Electric (GE) ... an integral component of the Dow Jones history since it's the only company from the original 12 to still be part of the DJIA despite being removed twice.

The DJIA didn't gain much popularity outside the confines of Wall Street in its first fifteen years. Why? Primarily because in 1896, investing in the stock market was considered highly speculative. Few people ventured beyond bonds and railroad companies when it came to investing.
The result? Not much attention being paid to an index that tracked stocks.

The Middle Years
Attitudes toward stock investing changed drastically by the time the 1920s rolled around. The average citizen was now investing in stocks. The result?
The Dow climbed from its modest range in the 100s to a whopping 400!
But this didn't last long. The crash of 1929 put a hard ceiling on this number. For the next 25 years the Dow stayed below 400 owing largely to the economic turbulence from both the 1929 crash and World War II.

1950 - 1999
The 1950s saw a meteoric rise in the Dow .... almost 250%. The 60s and 70s didn't see anything as dramatic. It wasn't until the 1980s that the Dow charged ahead into unprecedented heights, a pivotal moment in the Dow Jones history. The 80s and 90s were by far the most prosperous years for the stock market as a whole ... and the Dow rose an astounding 228% during the 80s and 317% during the 90s.

2000 - current
The dotcom crash in early 2000 sent the Dow spiraling downwards. The World Trade Center attacks made the slide even worse. It wasn't until 2003 that the Dow climbed past the 10,000 mark again.

Oct 9, 2007 saw the Dow at its highest point ever.... 14,164.This was an important milestone and it also marked the end of the longest ever US bull market.

The economy in the US and around the world started melting down in 2008. The next couple of years saw sharp swings in the Dow with the overall trend being downward. The Dow teetered up and down the psychological 10,000 point mark. 2010 ended with the Dow at 11,577.51.

How is the Dow Calculated?
A discussion on the Dow Jones history wouldn't be complete without answering this question.
Quite amazingly, the calculation for the Dow has remained almost the same since its inception.
First, you add the prices of the 30 companies that make up the Dow ... the price is picked from the primary exchange the stock is traded on.

Next, you divide this number by a what is called a divisor. This divisor is not simply the number of companies making up the Dow. It's an adjusted value designed to keep the index consistent through stock splits, dividend distributions, etc.

So, for instance, a 3:1 stock split on any of the component companies would triple the number of existing stocks, while the price would tend to drop by a third. The adjusted divisor ensures that this sharp drop in price doesn't plunge the index down.

The formula for the more mathematically curious is:
Dt+1 = Dt * Σ Ca t /Σ Ct
Dt+1 = Divisor to be effective on trading session t+1
Dt = Divisor on trading session t
Ca t = Components’ adjusted closing prices for stock dividends, splits, spin-offs and other applicable corporate actions on trading session t
Ct = Components’ closing prices on trading session t

In summary, we looked at what the Dow is, traced the Dow Jones history, and peeked into how the index is actually calculated.

The Dow is indeed the defacto bell-weather of the stock market and is valuable in assessing the overall strength of the market.

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