Is the Dow Jones Industrial Average Where It Ought to Be?

In the nineteenth century, investing in publicly traded stocks was properly considered a highly speculative enterprise. There was little reliable independent information and businesses tended to hide bad economic news. With the collapse of Enron and WorldCom, we have recently become reacquainted with this behavior. Nineteenth century investors wisely preferred to invest in corporate bonds that promised regular payments backed by real collateral. Information about the stock values of companies was so sparse and unreliable that it was often impossible to assess the current general health of business stocks.

In stepped journalists Charles Dow and Edward D. Jones. In 1882, they formed Dow, Jones, and Company. The company started publishing subscription newsletters with business information. The newsletter eventually evolved into the now famous Wall Street Journal. In 1884, they created the Dow Jones Industrial Average as a measure of general stock market performance. The original index consisted of only 11 companies, including nine railroads. There was a certain logic in heavily weighting railroads. Not only were railroads large industrial enterprises but the economic performance of railroads also indirectly reflected the fortunes of other companies that shipped via railroads.

Over time, the list of companies grew and changed radically. Presently 30 are included in the index. Many of them like Boeing, Hewlett Packard, International Business Machines, and Intel reflect the changing nature of the economy in the past one hundred years. Now there are many more market indices. The Standard and Poor’s 500 represents the collective performance of 500 of the countries biggest companies. The Wilshire 5000 is so large that it measures essentially the returns of almost all publicly traded US companies.

The present value of the Dow Jones Industrial Average is that it provides an exceptionally long time series of economic performance. Whereas the Dow began in the nineteenth century, the Wilshire 5000 began in only 1974. Hence, even though the Dow may be a narrow and imperfect index, it is the best we have to monitor and study long-term variations in stock performance.

Figure 1 is a log plot of the Dow Jones Industrial average since its inception. The most conspicuous feature of the time series is its relentless growth. There is a clear persistent dip in the index during the Great Depression in the 1930s. However, decade-in-and-decade-out the stock market and the Dow yield strong positive returns. Plotting the index on a log graph emphasizes the variations. If plotted on a linear scale, the general upward movement in value would be ever more conspicuous.
This increase has been so persistent and the rise from January 1980 to January 2000, when the market peaked at 11,700, was so rapid that some have become overly optimistic. In 1999, James Glassman and Kevin Hassett suggested that people now realized that in the long run stocks provide larger and more reliable returns than other investments. This new understanding would drive up prices. Glassman and Hassett predicted that, “Stocks are now, we believe, in the midst of a one-time-only rise to much higher ground — to the neighborhood of 36,000 for the Dow Jones Industrial Average. After they complete this historic ascent, owning them will still be profitable but the returns will decline.” Given that the Dow is now below 8,000, it does not seem likely that we will see the Dow at 36,000 any time soon. The recent plunge in the market has devastated the retirement plans of many and a subtle fear is becoming palpable.

While the effects of the decreases in stock values since 2000 are very real, a closer examination offers modest room for hope. Figure 2 is a log plot of the Dow Jones Industrial Average from 1980 to the present. From 1980 to about 1995, the values of the stock market increased at a rate of over 10% per year. Then in 1996, the stock market literally exploded upward in what Federal Reserve Chairman Alan Greenspan then described as a fit of “irrational exuberance.” The straight line drawn in Figure 2 shows the increase in the Dow if it had simply followed the same healthy growth rate it had experienced from 1980 to 1995. The stock market would be approximately where it is right down. Holders of stocks would not be appreciably richer, but they would certainly feel less anxious.

Markets are never sufficiently disciplined or wise to grow along easily predictable straight lines. Markets that overshoot the long-term growth rate will likely undershoot that same growth rate for a while. The pain is not over. Nonetheless, the fact that the Dow is about where we might expect it to be given its long-term growth rate offers a least a small ray of comfort for those who have lost many paper profits over the last few years. Or perhaps this is just “whistling past the graveyard.”

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