DOW - 8000

TO MOST casual observers, the fact that the Dow Jones Industrial Average (DJIA) has bounced back every time it dipped below 8,000 points (see attachment) over the past few months - even when there is bad news - suggests that the 8,000 mark is where the 'support' or the magical 'market bottom' lies. This means that as soon as the index nears 8,000 on the downside, chartists and traders will start calling a 'buy' on the market.

Closer examination, however, reveals that the bounces around the 8,000 mark are simply a function of the way the index is constructed. Because the Dow is price-weighted, it is also inherently flawed.

In Thoughts from the Frontline weekly newsletter dated Jan 23, writer John Mauldin correctly points out that the divisor for the DJIA is 7.964782, which means that for every dollar an index stock falls, the DJIA falls 7.964782 points, regardless of the stock's capitalisation.

As a result, if the stock of Microsoft, with a price of US$17 and a market cap of US$156 billion, was to crash to zero, the DJIA would only lose 135 points (17x7.964782). But if the same was to happen to IBM, with a smaller market cap of US$124 billion but a higher share price of US$92, it would cost the index to lose a whopping 700 points.

Now consider the four financial stocks currently in the DJIA - Citigroup (US$3.90), Bank of America (US$6.78) Amex (US$16.70) and JPMorgan (US$25.43) - using last Thursday's prices.

If all four stocks were to crash to zero, the DJIA would only lose 300 plus points, not that huge a loss in the context of the market, yet imagine the repercussions on the US and global economies if these four institutions collapsed totally.

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 (General Motors' shares, for example, are now just above US$3).

In other words, 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 bad news is released, thus giving the mistaken impression of resilience to adverse news and of strong support around 8,000 points.

By right, these financial and auto stocks should have been removed from the index, given that it has been past practice to replace stocks whose prices drop below US$10.

For some reason, the DJIA's guardians have been reluctant to do the same now, possibly because of the political fallout that might ensue - imagine the repercussions of removing pillars like Citigroup or General Motors.

This then leads to the inevitable conclusions: the DJIA is not comparable over time; the only reason the DJIA appears well-supported around 8,000 is because the collapsed financial and auto components have not been replaced as they should have been; and that movements in large-price stocks are magnified because the index is heavily skewed in favour of these counters.

If the index was to be correctly re-balanced by removing the battered financials and autos and replacing them with stocks with prices above US$10, you'd have to wonder whether the 8,000 mark would hold as well as it has.

You'd also have to dismiss arguments that it is safe to buy since the index is at its lowest level in many years because historical comparisons are invalid - unless, of course, the same re-balancings that were done in the past are performed now.

via Business Times