Never mind all that talk about the stock market being too high. The Dow Jones industrial average at 10,531 may be way too low.
That doesn't mean the 30 stocks in the Dow average are attractively priced. It's just that the best-known measure of U.S. stocks hasn't captured the full effect of the eight-year bull market.
Why? Because the calculators of the Dow use what in the opinion of many economists and investors is an antiquated method that lowers a company's weighting in the average when it splits its share price.
The 30-stock benchmark would be hovering near 13,000 if it were calculated by the method that makes sense to most professional investors, ignoring splits, according to money manager Robert S. Salomon Jr.
"The Dow would be much higher, and it would [reflect more] the way you and I manage our investments," said Salomon, a principal in STI Investment Management.
The Dow, owned by Dow Jones & Co., is the simplest type of index, essentially an average of its companies' stock prices. That means that J.P. Morgan & Co., with a stock price about $135 as of Tuesday, has about four and half times the impact on the Dow as Walt Disney Co., at about $30 a share--even though Morgan's total market value is far less than Disney's, $24 billion compared with $61 billion.
A company's weight in the average drops when the company splits its stock, even though a split has no effect on underlying value.
IBM, the highest-priced Dow stock at about $221 a share, now carries the most weight. But after the company splits its stock 2 for 1 on Thursday, IBM will fall to fourth in importance.
Investors who own a portfolio of stocks that tracks the Dow will have to sell half of their IBM shares when the split occurs to match it.
"That is kind of an unusual strategy," said Gus Sauter, who runs the $190-billion stock index investing unit at Vanguard Group. "It's highly tax inefficient."
This anomaly is the big reason Vanguard, the biggest manager of index mutual funds, doesn't offer a fund linked to the Dow average, and why professional investors use the Standard & Poor's 500 Index, which is weighted according to total market value, as their benchmark. The S&P 500 also is a better reflection of how large-capitalization stock investors, on average, are doing.
