CFD traders have a wide choice of indices to trade around the world, but one question we are often asked is which is the best US index to trade. Clearly the Nasdaq is self-explanatory, but the Dow Jones and S&P 500 indices are both quoted frequently in the financial press. Traditionally the Dow has been the headline index, but most technical and fundamental analysts tend to examine the S&P when taking a big picture view of the US economy and stockmarket.
The reason that this question is important right now is that in the last month or so the Dow Jones has moved to new all time highs, passing the peak last seen in January 2000. But the S&P 500 is still around 8% off its high of seven years ago, so why there is so much difference? Its to do with the way each index is calculated.
The Dow Jones is a very simple index, and is price-weighted as opposed to the Nasdaq and the S&P which are value-weighted. The latter are calculated from the monetary value, or market capitalisation of each constituent. This is worked out as the shares in issue multiplied by the stock price, and is thus a good representation of the overall value of the constituents.
With a price-weighted index, however, one simply takes one share of each company, adds them all and then calculates a divisor, which for the Dow was 30 at the start, and then adjusted for splits and substitutions over the years. The simple problem with this is that companies with higher share prices are given more weight in the Dow Jones.
What has happened as an example is that General Electric and Microsoft, which are amongst the highest valued companies in the index, have much smaller weightings than they should (GE stands around $35 and MSFT at $29, against say Johnson & Johnson at $65). Another problem with a price-weighted index is that each dollar change of a component affects the average by the same amount, which is approximately 6.5 points, working on the current divisor. One can have a situation where an equivalent percentage move in the most expensive stock, currently IBM, can be worth around five times the lowest priced constituent, Intel. Sounds crazy? Yes, but thats the way the Dow is calculated.
So how do the 30 components of the Dow compare to the year 2000 highs? Nine of the components are above where they were, 12 stocks are more than 10% below and 15 are more than 20% below their January 12th, 2000 close. Well leave you to judge how important that makes a new high on the Dow, even though it is still the headline index for many CFD traders.