|The Colorful History and Enduring Legacy of the Dow Jones Industrial Average|
By John Prestbo
Among history’s interesting ironies is that of the journalist who is famous for his numbers, not his words. Charles Henry Dow, founder and first editor of The Wall Street Journal, invented the Dow Jones Industrial Average. It became the most widely quoted indicator of the U.S. stock market ― and not just within the United States but around the world.
This chapter relates how it became a global icon of equity investing long before it was permitted to be the basis of indexed investment vehicles.
Charles Dow was born November 6, 1851, on a farm near Sterling, Connecticut. His father died when he was six, and his mother saw to it that he attended the one-room schoolhouse to gain a basic education. At age 16, he set out on his journalism career, beginning at a weekly newspaper and moving up to dailies in Springfield, Massachusetts, and Providence, Rhode Island. His reporting reflected an interest in history and economics, which attracted the attention of a group of financiers that were interested in the silver rush at Leadville, Colorado, in the late 1870s. They invited him along on a three-month tour of the area. He wrote stories about grubby prospectors who became millionaires overnight (and sometimes became paupers again just as quickly by drinking and gambling in saloons). He wrote, too, of rich businessmen who flocked from far-away cities to get in on the action, and of the sizable companies these tycoons built by acquiring full and partial interests in hundreds of bountiful mines. The financiers in Mr. Dow’s party talked frequently and enthusiastically about the appeal that mining stocks would have back on Wall Street.
Thus did “Charlie” Dow become fascinated with business, finance and investment. Not surprisingly, when he headed back east after the mine trip he went to New York rather than returning to Providence. After a stint on the New York Mail and Express, he joined the Kiernan News Agency, which gathered news on Wall Street and distributed it by means of handwritten bulletins on thin paper known as “flimsies,” which messenger boys scurried to deliver to clients throughout the day. He persuaded John Kiernan to hire a journalist friend from Providence, Eddie Jones, and before long the two were talking about starting their own news company. They did so in 1882, in large part with the financial help of a frugal Pennsylvania Dutchman named Charles Bergstresser, who also worked at Kiernan. Mr. Bergstresser was content to be a “silent partner” as well as a working journalist at the new Dow, Jones & Company.
While Jones and Bergstresser handled the “hard,” breaking news, the professorial Dow began writing analytical pieces that were a new contribution to the Wall Street scene. He had two basic topics, the economy and the market, and he tended to view any other subject such as politics through those prisms. These pieces became more substantive as Dow Jones evolved from a bulletined news service into a newspaper publisher, first of the Customer’s Afternoon Letter in 1883 (basically a compilation of the day’s “flimsies”) and then of The Wall Street Journal, beginning in 1889.
Dow needed something to represent the stock market in his analytical dissections of the economy and investor behavior. His simple solution was selecting several actively traded stocks and averaging their closing prices from time to time. He first used this device in the Customer’s Afternoon Letter of July 3, 1884, citing the average of eleven stocks, nine of which were railroads. [See Table 1.] Readers didn’t quarrel with Dow’s methodology, but they complained that he didn’t include enough stocks in his average ― grumbling that echoes through the decades to today. Over the next three years he experimented with averages consisting of twenty and then thirty stocks. Then he noticed that however many stocks he was tracking, his averages all portrayed the important advances and declines in the market. The key wasn’t the number of stocks but selecting truly representative ones, which is equally true now.
This task required talent, and surely his front-row seat overlooking the market combined well with his native intelligence to hone his skills. What few people know, however, is that Dow also spent time on the trading floor of the New York Stock Exchange as a full member, executing orders, while maintaining his duties at Dow Jones. His motive wasn’t money but friendship with an Irish immigrant who wanted to set up a brokerage firm but had to become a citizen to obtain exchange membership. Dow joined the friend’s firm and the exchange for just the five years and four months it took for his friend to be naturalized, a period that ended April 30, 1891. This hands-on experience added insight and credibility to his writings about the market as well as to his ability to identify the representative stocks he needed for his averages.
Though railroads were the mammoth corporations of the day, and thus dominated Dow’s early averages, he had his eye on a new, budding segment of the market: industrial companies. He observed, as he had in Leadville, the combining of smaller, proprietor-owned and family-run businesses into sizable corporate entities that sooner or later offered shares to public investors. He understood that this trend in time would create an industrial sector big enough to be the primary engine of U.S. economic growth in the fast-approaching Twentieth Century. In the meantime, however, he couldn’t find more than two or three industrial stocks that attracted investor interest of the magnitude the railroads commanded.
Finally, in 1896, Dow finessed that issue by creating an average consisting of 12 industrial stocks [see Table 2] and remodeling his older average into the 20-stock Dow Jones Railroad Average. The Dow Jones Industrial Average made its first appearance in The Wall Street Journal on May 26 of that year at 40.94. Dow cited it and the railroad average from time to time in his market commentaries. Five months later, in October, the Journal began running the averages every day, indicating that readers wanted to make use of them in their own ways apart from Dow’s applications. (By that time, the industrial average had fallen 30% to 28.48 on August 8 and was slowly recovering. Thus, the average’s first significant move was down.)
Dow used his averages to study the markets, and he wrote about his findings in a series of editorials that began in 1899. He found cycles in market behavior, just as he had in the economy. For these observations alone Dow is sometimes identified as the “father” of technical market analysis, which focuses on price movements and trading volume to discern patterns that more or less repeat themselves. But he was equally attentive to “fundamentals” such as dividends and, for railroads, car-loading statistics, which provided insight into the economic and financial trends that the market was reacting to. His writing style was stiff by contemporary standards, but occasionally he transcended the particulars and set down vivid metaphors of how these invisible forces worked. One example comes from the Journal of January 31, 1901:
A person watching the tide coming in and who wishes to know the exact spot which marks the high tide, sets a stick in the sand at the points reached by the incoming waves until the stick reaches a position where the waves do not come up to it, and finally recede enough to show that the tide has turned.Note that Dow’s choice for the “peg” is the 20-stock railroad average. Even nearly five years after its birth the industrial average was tracking a sideshow in a market where railroads reigned as the center ring attraction. But that situation was about to change. About a month after that editorial appeared, J.P. Morgan welded two big steel companies into a single corporate giant, United States Steel Corp., which quickly acquired five more steel makers. It not only instantly became the biggest industrial company in the country, but also the first $1 billion-plus corporation (with capital of $1.4 billion) on Earth.
This method holds good in watching and determining the flood tide of the stock market. The average of twenty stocks is the peg which marks the height of the waves. The price-waves, like those of the sea, do not recede at once from the top. The force which moves them checks the inflow gradually and time elapses before it can be told with certainty whether the tide has been seen or not.
Dow hustled U.S. Steel’s common and preferred shares into the industrial average on April 1, 1901, along with three others. One of the stocks dislodged in this move was General Electric Co., among the original industrial dozen. It had already been dropped once, in 1898, and reinstated the following year. GE didn’t make it back into the industrials until 1907, when it replaced yet another steel company gobbled up by U.S. Steel. (Teddy Roosevelt the trustbuster agreed to look the other way in return for Mr. Morgan rescuing the U.S. economy from the Panic of 1907.) This time, GE stayed put and remains a component of the Dow Jones Industrial Average to this day.
“The probable activity and possible investment value of U.S. Steel will attract new attention to industrial properties,” Dow wrote on the eve of adding the new giant’s stock to his industrial average. In time, he prophesized, “trading in railroad stocks will decrease and the industrial market will become the great market in Wall Street.”
And it came to pass as Dow had foretold, but he did not live to see it. His health deteriorating, he and his remaining partners – “Eddie” Jones had left in 1899 – sold the company in March 1902 to a Boston business-news entrepreneur, Clarence Barron, whose descendants still control it. Nine months later, on December 4, 1902, Charles Dow died of a heart attack in his Brooklyn home.
That his legacy, the industrial average, is the “language” people everywhere use to describe what the U.S. stock market has done, is doing and will do surely would astonish Dow. He probably would be pleased and dismayed in equal measure – proud that his creation still monitors the mighty engine of U.S. economic growth into the Twenty-First Century, but upset that the average’s outward show of statistical precision is used by some to lend credence to their stock-promotion schemes. There’s no evidence in Dow’s market commentary (and he kept no diary nor wrote any letters revealing his private thoughts) that he regarded his average as anything other than a device to assist in probing and dissecting the nature of the market.
William Peter Hamilton, however, had other ideas. He had come to work for The Wall Street Journal in 1899, following market-reporting stints in London, Johannesburg and New York. Hamilton was impressed by Dow’s ability to examine and explain stock market behavior. He particularly was captivated by Dow’s use of the industrial average to illustrate market performance, and he studied intently at the master’s feet. But Hamilton did not put pen to paper on the topic of market analysis until after Dow died. Beginning in 1903 and continuing until his own death in 1929, Hamilton wrote prodigiously to explain and elaborate upon Dow’s commentary and then to apply it to the market he observed at first hand. By one count, he wrote 252 editorials on business and finance that appeared in the Journal, of which he became the fourth editorial page editor, and in Barron’s, of which he became executive editor. Some of his writings formed the basis of a book, The Stock Market Barometer, which was published in 1922 and sold through seven editions; a “revival” edition is available today on Amazon.com and at Barnes & Noble.
Though Hamilton did more any other one person to legitimize it, he apparently did not coin the phrase “Dow Theory” to summarize Dow’s collective market observations and analysis. For that matter neither did Dow, who made no claims to advancing a “theory” of market behavior. The phrase seems to have appeared first in 1903 in The ABC of Stock Speculation, published by S. A. Nelson as part of Nelson’s Wall Street Library series. (That book, which quotes Dow extensively, also is available to present-day readers.) In 1921, a reader wrote to the Journal to complain that he had followed the Dow Theory but hadn’t made any money. An editorial, presumably written by Hamilton, replied that the Dow Theory was a barometer of market, not a guide to gambling in it. However, the Journal thereafter avoided using the term “Dow Theory” except to repeat the barometer metaphor. Disciples from outside Dow Jones & Co. picked up the Dow Theory banner and carried it forward to the present day, notably Robert Rhea and Richard Russell.
Dow’s 12-stock industrial average was enlarged to 20 stocks in 1916 and to 30 stocks in 1928, where it remains.
The editors of the Journal offered no explanation on either occasion but they probably were responding, at least in part, to unremitting calls for additional stocks to be included. Of far more statistical significance in the 1928 remodeling was the conversion of the average to an index. Originally, Dow simply added the prices of the stocks and divided by the number of stocks. But over time that procedure proved cumbersome as some components were replaced and others split their stocks. Suppose a company in the industrial average issues one new share for each share outstanding. After this two-for-one “split,” each share of stock is worth half what it was immediately before, other things being equal.
But without an adjustment in the divisor, this split would produce a distortion in the industrial average. Here is a simplified example: Assume three stocks selling at $5, $10 and $15. Their average price is $10. If the $15 stock is split three-for-one it subsequently sells for $5. Nothing has happened to the value of an investment in these shares but the average of their prices now is $6.67, not $10. An adjustment must be made to compensate so that the “average” will remain at $10. In this example, the new divisor would be 2 instead of 3. In 1928, the editors decided henceforth to adjust the divisor – the number that is divided into the sum of stock prices – from a base level to compensate for future pricing distortions. For most modern indexes the base level is 100 or 1000 or similar round number. But the industrial average was 32 years old at that point, closing on Saturday, September 29, 1928, at 239.43 with a “divisor” of 20 stocks. (Yes, the market was open on Saturdays in those days.) On the following Monday, October 1, it had 30 stocks and a divisor of 16.67. That was the number necessary to reproduce with 30 components a value equal to the preceding Saturday’s close. The use of the word “average” in the name continued out of habit. Indeed, some people on Wall Street call all security indexes “averages” even though, unlike the industrials, they never were.
Besides stock splits and substituting one stock for another, the divisor also is adjusted for other corporate actions such as spin-offs, rights offerings and special or unusually large cash dividends. (Normal cash dividends are not taken into account in the calculation of the Dow Jones Averages, though they are used in total return calculations.) Most changes in the divisor are downward, and in 1986, after a two-for-one split by Merck & Co., the divisor fell below one. When you divide a positive number by a fraction, the result is always greater than the number being divided. That’s why you can sum the closing prices of the 30 Dow stocks and not come close to 7000, 8000 on up to the record of 11722.98 (set Jan. 14, 2000); but when you divide the sum of prices by a divisor of 0.145 something, you get numbers that big. Some people seem to think this magnification effect is fishy, but it is just ordinary arithmetic. What they lose sight of is “The Dow’s” longevity. That a $1 move in any Dow stock can cause a nearly 7-point move in the industrial average – assuming all 29 others are unchanged – is a reflection not only of countless divisor changes but also what happened to the value of $1 over the course of two world wars and several smaller ones, a Great Depression and more than a few recessions, and the transformation of the United States from an agrarian country into the richest and most powerful sovereignty on the planet.
Still, the question remains: Why has the Dow Jones Industrial Average prevailed over all these years to remain the most-watched market index in the world? There are three reasons:
First, The Dow was first. Because it is the oldest market indicator, it also was the first to be quoted by other publications. This practice became convention when Wall Street earned at least a mention in the general news each day, and habit became a requirement by the time the post-World War II bull market galvanized the nation’s attention. The industrial average became the indicator to cite if you were citing only one. Moreover, generation upon generation of investors became aware of and then familiar with the market via The Dow. Though some professionals use more-encompassing indexes in their investment work, they still chat about market moves in the shorthand of Dow numbers.
Second, The Dow is reliable. Longevity wouldn’t mean much if The Dow were out of step with reality. But it doesn’t lead people astray as to what the market is doing. For 30 years there wasn’t any other index to check The Dow’s dependability. Then in 1926 Standard & Poor’s Corp. developed the first market-capitalization-weighted index, the S&P 90. By the 1950s, it had evolved into the S&P 500, a benchmark widely used today by professional money managers. Today, indexes abound. The largest of all U.S. benchmarks is the Wilshire 5000, which actually contains about 7,000 stocks, which also are weighted by market value rather than by price. Though The Dow has many fewer stocks and a different computation methodology, it relays the same stock market story as these other indexes. [See Table 3.]
Third, The Dow is understandable to a vast segment of adults. All the stocks in it are familiar names, and people rightfully expect that no obscure stock will be chosen for membership. The editors of The Wall Street Journal select the components of the industrial average. Taking a broad view of what industrial means, they look among substantial companies with a history of successful growth and wide interest among investors. It is a subjective judgment, not a quantitative one. The components of the DJIA are not changed often because the Journal editors believe that stability of composition enhances the trust that many people have placed in it. The most frequent reason for changing a stock is that something is happening to one of the components, such as being acquired. Whenever one stock is changed, the rest are reviewed.
Another factor in understandability is that there are only 30 stocks – enough to achieve proper diversification, according to academics, and also to comprehend easily. The Dow is closer in size to most investors’ personal portfolios of individual stocks than any other well-known index. Of course, the word “average” in the name is a tad misleading, but the method of calculation isn’t so far removed from what we learned in grade school. In short, people can relate to The Dow on a human scale, tucking it in a corner of their heads as one of many gauges they monitor in navigating their way through increasingly complex days.
One last bit of history: For 100 years, Dow Jones refused to license its industrial average as the basis of any investment products, such as mutual funds, futures and options. The company considered The Dow to be a crown jewel so valuable to its reputation that it saw little to gain by risking its good name in the hands of money managers and investment companies with far different agendas than a publisher. In 1982, the company successfully went to court to stop the Chicago Board of Trade from trading a futures contract based on the average.
The company’s resistance resulted from concern that futures and options in particular were inappropriate for many investors, and concern over their possible negative effects on the underlying markets. But some 15 years later the company’s leaders became convinced that experience with such products and safeguards designed by regulators and the exchanges made the time right to consider licensing indexes. In June 1997, Dow Jones granted licenses to the Chicago Board of Trade for futures on The Dow, the Chicago Board Options Exchange for options on The Dow and the American Stock Exchange for an exchange-traded fund known as DIAMONDS. Growth was slow in the new products until the bear market arrived in March 2000, when The Dow proved more resistant than many other indexes to declining prices and increased volatility attracted futures and options players. By 2002, the futures and options were among the most actively traded contracts in Chicago and the ETF had attracted about $5 billion in assets and brisk trading interest.
But even with this relatively recent entry into the index provider business, Dow Jones & Co. sticks close to its publishing roots and its commitment to journalistic independence. The company doesn’t sponsor, promote or endorse the investment products based on its indexes.