30 October 2004
This article is broken down into two parts:
There are people who will not desire to read the history and construction of the DJIA. Those readers should go directly to Parts 2 of this article. Part 2 contains all of the charts and commentary on the DJIA Bear Markets.
Any date referred to in this article is referencing the date of issue from the copy of Barron's where the data could be found.
Part 1
There are things in life that are learnt the hard way, one thing being that there is a time to buy, and a time to sell every investment. Still, knowing this doesn't answer the question, when to buy or sell an investment. I would like to share with my readers some interesting details I have discovered in my research using weekly closing prices of the Dow Jones Industrials (DJIA) that I have gleamed from old issues of Barron's. As Barron's was not published until May of 1921, I used the book "The Dow Jones Averages 1885 - 1990" to obtain the data for the years previous to Barron's first issue. It needs to be noted that Dow Jones also publishes two other "averages" the Dow Jones Transports and the Dow Jones Utilities Averages. I do not address these other averages in this article but their composition is identical to the Dow Jones Industrial Average.
Charles Dow, in 1884, was first to create a means to measure the stock market. His method was brilliant, if simple. Dow made a simple average of eleven popular large cap stocks by adding them together, and divided the result by 11 at the close of every day's trading. No one had done this before, devising some means to measure the stock market as a whole. The NYSE stopped being a market of stocks and became a stock market with the creation of Mr. Dow's 11 Stock Average in 1884.
This first average was not the Dow Jones Industrial Average (DJIA) as the popular shares used in this first stock average were all rail road stocks. In 1885 this stock market average was increased to 14 companies. It is with this 14 company average that I use as my starting point. A Dow Jones Industrial Average was first devised on 26 May 1986. This original DJIA had only 12 industrial shares on it, and the only company that has survived to this day with its original name is General Electric. It seems that General Electric has been in the DJIA since its inception. The DJIA was expanded to 20 shares in 1916 and the final arraignment of 30 industrial companies was compiled on 01 October 1928.
Chronology of the Dow Jones Industrial Averages:
1884: 11 company Stock Average created (data not given in my sources)
1885: 14 company Stock Average created
1886: 12 industrial company DJIA
1916: 20 industrial company DJIA
1928: 30 industrial company DJIA
As you can see here, there is no one Dow Jones Average that goes continuously from 1885 to present. I had to use all four Dow averages from 1885 to 1928 for my data. To enable these four different averages to be used as one data series, I used a correction factor to merge one average into another. For instance if one average stopped at 10 and the next average started at 20, I multiplied each data point in the older average by 2. Using a correction factor in no way effects the percentage movements in the DJIA as it moves up or down.
The Dow Jones Industrial Averages are just that: an average of share prices. This makes the Dow "Price Weighted." What this means can be shown using the Lundeen 2 Stock Average, as an example. The Lundeen 2 Stock Average has only two companies in it, one company has a $50 share price and the other company has a $10 share price. If each share price were to rise, or fall, by 5% in price on a given day, the company with the $50 share will have five times (5X) as much effect on the price of the Lundeen 2 Stock Average than the $10 stock would have. The DJIA has this same characteristic. The more expensive the share price of a company is, the more "Weight" it has in the average. "Price Weighting" means the market measure uses share price as the market variable being measured. The effect of Price Weighting is that the higher priced stocks have more weighing in the average than the lower price shares.
This is a problem with price weighted averages, or any market measure that measures share prices. What if the $10 stock has the huge market capitalization of a company like General Electric, while the $50 stock in the average has a much smaller market capitalization? Can a market measure that could, and sometimes does, gives more weight to a much smaller company than it does to giant General Electric render an accurate measurement of the market? Why does Dow Jones Inc. keep computing their stock market series as a price weighted average if General Electric's stock price could be pushed aside by a much smaller company? The answers to all these question is that twenty years after the American Civil War, everything a publisher did to get a newspaper out on the street was done without a modern calculator. A price weighted average could be done using the 19th century technology of paper and pencil. Besides, market watching is not rocket science. All you can hope for with any market measure is that it will to go up in bull markets and go down in bear markets with the majority of stocks in the stock market. Few are the stocks that exactly match the advances and declines of the DJIA, if any. This is true for any market measure.
To change the method of computing the DJIA now, when it would be very easy to do so, would create a breach in the 119 years of market history recorded in the Dow Jones Industrial Average. I think Dow Jones Inc. is wise to leave well enough alone and keep a good thing going. The Dow Jones Industrial Average will remain a price weighted average.
I need to note that all but one company, General Electric, of the original shares that were in the 1886, 12 company, DJIA are now gone. Dow Jones has had to replace many companies in the past 119 years whose share prices have once been, but are no longer averaged into the Dow Jones Industrial Average. Also General Electric, as had other companies in the DJIA, has declared many stock splits over the years which causes change in share price not related to trading of its shares. Price changes due to switching companies or stock splits must be corrected.
To maintain an accurate measure of the stock market, whenever a new company is added, or a company currently in the DJIA declares a stock split, the Dow Jones Publishing Company divides the DJIA by a "divisor" to correct any change due to switching companies or stock splits. This is much the same as what I did to make the four Dow Averages, from 1885 to present, into one continuous market measurement.
There are other methods used to measure a market - "indexing" is one of them. This is where the share prices or more typically, market capitalization in dollars, of the companies used in the index are added together. As this produces a very large number, it is indexed. Indexing is done by taking the combined share prices or market capitalizations, of the desired companies selected to be indexed, on the first day of the series and dividing it by itself. As any number divided by itself, is equal to "1" it effectively reduces the large resulting number to a much simpler smaller number. Each data point thereafter is the result of that day's new combined share prices or market capitalization divided by the first data series combined share price or market capitalization. Indexing goes like this.
As you can see, to index anything, either share price or market capitalization, you only have to divide each data point in the series by the first data point. I do it all the time with my spreadsheet. Usually each day or data point in the series is multiplied by a factor of 100. However when I index, I prefer to keep the first data point at "1" rather than "100." Either way the charts created are identical in * percentage * moves up or down
A good example to see how Dow Jones Inc. uses indexing to measure the various stock market sectors is to look at the Dow Jones U.S. Total Market Industry Groups, published daily in the Wall Street Journal or weekly in Barron's. Dow Jones gives an excellent explanation of the composition of its indexing of the various American Stock Market sectors at the top of the table listing the data. This series of market indexes are "Weighted by Capitalization" (Market Capitalization) and use 31 Dec 1991 as 100.
This means that each daily Market Capitalization for each series, going back to 31 Dec 1991, is divided by its market capitalization of 31 Dec 1991, and then multiplied by 100. An index in the Dow Jones Total Market Industry Group that is at 200 has increased 100% since 31 Dec 1991, a doubling in value. An index that is at 50 would mean it had fallen by 50% in value since 31 Dec 1991, its value was cut in half. This is a nice feature of indexing, it is easy to see when an index doubles or is cut in half. There is no reason why someone could not index the DJIA or their personal portfolio to take advantage of an index's ability of more easily displaying percentage performance.
Indexing does get rid of the problem where a small company with a large share price pushes around General Electric. But now General Electric pushes around the smaller companies. Indexing market capitalization of stocks really is more logical than averaging share prices. But strangely, the averaging of share prices in the DJIA and the indexing of market capitalization with the S&P500 produces charts that closely follow each other over time. Using either the DJIA or the S&P500, the rise and fall of the stock market can be seen.
So with averaging share prices or indexing market capitalization, there are problems with any measure of the market as some component in the measurement of the market will have greater influence than others in the measurement. Personally, I think the best market measurement is an index of either share prices of stocks you own or better still, the market capitalization using share price multiplied by the number of shares you own of the companies in your own portfolio. In other words, indexing your portfolio's net worth. Your portfolio after all is the only market you have money in.
I am not recommending that you ignore widely followed public measures of the market like the DJIA or the S&P500 as both are excellent benchmarks for the general market. But one thing the DJIA has that no other market measure has, is that the Dow is the most watched market measurement in the world. And because it is so old there is much that can be learned from it about the stock market during times of booms and busts for over a hundred years that other newer market measures can not offer.
Part 2
Above is the chart showing the DJIA weekly closing prices from 1885 to present. Looking at this chart of 119 years of DJIA history, it doesn't look like much of a stock market until 1955. Where is the market crash of 1929? To get a better look at the history of the DJIA we can look at the data charted logarithmically.
To understand data charted with a logarithmic scale, or "Log Scale", look over to the left hand Y-Scale. Looking at 1, 10, 100, 1,000 & 10,000, each is 10X larger than the number below it, but 10X smaller than the number above it. We are not scaling by numbers here, with Log Scale we are scaling by percentages. Each number is 1,000% or 10X bigger or 10X smaller than the number below it or above it.
With the DJIA charted on a log scale we can clearly see that the 1929 - 32 bear market was the most significant event, if not a big deal in the DJIA history. But where are the other bear markets? As the reality of the stock market is that significant bear markets do occur, we must look at the DJIA data in a different way to see them.
In the next chart, each data point was derived by the following formula:
Here is 119 years of Bear Markets in the DJIA.
I wish I could say that I came up with the above charting technique all by myself; but I did not. About 12 years ago, in an old Dow Theory Letters by Mr. Richard Russell, a fellow subscriber whose name I did not note (SORRY) sent a similar chart to Mr. Russell. He liked it and shared it with his subscribers. I have not seen Mr. R. use this technique since that particular issue of his letter. Even so, I would not be surprised if he personally uses it every now and then as it is so useful in seeing the risings and falls in the stock market over very long periods of time.
This technique fixes every new DJIA all time highs at zero and shows every other data point at some negative percentage below the DJIA's last all time high. Effectively, the algorithm used keeps the very first DJIA weekly closing data point of 1885 as the most significant data point of the chart, much like indexing, and so cancels out the effects of inflation of the US Dollar and manipulation of the stock market by "policy makers." This allows us to view on one chart:
of the past 119 years in the DJIA.
Here is what you are looking at. As with indexing, any number divided by itself is equal to 1. Whenever the DJIA reaches a new all time high, the above formula divides that DJIA's New All Time High by itself and produces a "1", never more. As each data point ( all 6243 DJIA weekly closing prices used in the chart) has 1 subtracted from it, each new DJIA all time high is now equal to *ZERO* and any other weekly close in the DJIA that is *NOT* a new all time high is shown at some percentage below its last all time high. We now can see 119 years of DJIA bear markets with the above chart using the above formula which creates a chart that I call "The Bear's Eye View." I suppose I could come up with a better name for this chart, but it does inform the viewer what they are looking at - BEAR MARKETS. So "Bears Eye View" it is as it explains what is being displayed.
REMEMBER, whenever the DJIA has risen to the * Zero Line * the DJIA has risen to a NEW ALL TIME HIGH. Any point below the * Zero Line * shows the DJIA at a percentage BELOW the DJIA's LAST ALL TIME HIGH. This chart allows us to see the significance of the 1929-32 bear market by comparing the Great Depression's DJIA bear market with every other market downturns from 1885 to October 2004. What a disaster! The 29-32 bear market was unique to itself in the 119 year history of the NYSE as measured by the Dow Averages. As you can see in the above chart of bear markets, there is nothing else like it before it or since.
The 1929-32 bear can only be described as a crater, it hides the market action of the Second World War. However, what happened before, during and after the Second World War is something I want to see. So I created the following chart.
I have reconfigured (Adjusted) the above chart so we can see what happened to the DJIA from the Great Depression to the beginning of the Cold War. Other than the period from July 1932 to November 1954, "the 22 year crater" in the DJIA, each Bear's Eye View Chart is identical to each other. The first "Bear's Eye View" of the DJIA was a continuous series that had 1885 as the starting point in each data point running up to October 2004. The "Bear's Eye View Adjusted" is composed from two distinct series. The first series in the "Adjusted" chart is from 1885 to the absolute bottom of the 1929-32 bear market found in the 11 July 1932 issue of Barron's. It is clearly visible on the chart where I ended the first series. The next series starts with the very next week's DJIA value. As the DJIA of 18 July 1932 is divided by itself, and then has 1 subtracted from it, it starts at zero. But remember, the second series in fact is still at the bottom of the worse bear market in history. So 18 July 1932, like the first data point in 1885, is not a New All Time High, just the starting point in a sequence of data points.
Some points stand out with the above Bear Eye View charts:
For four decades, from 1885 to 1919, had anyone closed out their position soon after any new DJIA all time high and waited until the Dow dropped -40% before they returned to the stock market, they would have been a stock market genius. You can see it in the above charts.
Did anyone ever actually use the "-40% Rule?" I can't say that I have read or heard that anyone actually did, but isn't the purpose of a market indicator, like the DJIA, to look for patters in the market? Looking at the Bear's Eye View of the DJIA before the 1929 Crash, a -40% correction was a well established A-OK flag that the bear market was over. I would be surprised if no one during the first 44 years of DJIA history didn't see this pattern and used it. Not that this matters in my article if someone did or did not.
For the practical purpose of making money in the stock market, the -40% rule worked for the last time in 1921. The -40% rule had a false signal in March 1938 (problems with Hitler and Czechoslovakia signaling the soon to start World War) that caused the DJIA not to go to a new all time high before it reached another -40% decline again in April 1942 (just before the Battle of Midway). The next time we see a -40% decline in the DJIA was in October 1974 and the -40% rule called it again, the bottom of a major bear market. But it was 53 years (1921-74) since the DJIA gave a -40% signal that was not the result of The Great Depression or The Second World War. Was anyone looking for it? Since 1974, 30 years ago, the DJIA has never corrected with a -40% move.
Looking at the DJIA Bear's Eye View for 1919 to 1934, above, we see where the -40% rule failed for the first time in detail. Above we see two -40% drops, one in 1921 and the other in early 1930. After the 1921 -40% flag the smart money would have reestablished their positions in the market. When the DJIA reached its next new all time high in January of 1925, market history would have told the smart money to close out their positions in a few weeks or months at most. The -40% rule said that money was made and now it was time to wait until the DJIA corrected by -40% before coming come back in. Or so the experienced investors thought.
For the first time, 1925, this did not work. After the smart money closed out their positions in 1925, they would have watched for the next 57 months, the DJIA go on from one new high to another. See my next chart of the DJIA from 1885 to 1934 below. For 57 months, except for one time, the DJIA was never more than -10% below its last all time high price. No one had ever seen anything like it before in the stock market. For people with money waiting to time their buying with a market pullback during the 1925-29 bull market blow off, keeping their cash on the sidelines until stocks got cheaper would have taken Superman. Look at the below chart of the Roaring Twenties Bull Market, we can see why this bull market sucked everyone in it. After 48 months, it had that can't lose feeling to it.
Going back to the Bear's Eye View 1919 to 1934 chart, in early 1930, for the first time in nine years, the DJIA had a -40% correction. Reading the financial publications of the early 1930's the all clear was sounded by the financial press. The rise above the -40% flag was a nice touch by the bear. Unfortunately, all who heeded this siren's call to action were sent straight to investor's purgatory and damnation. Just look at the Bear's Eye View 1919 to 1934 chart. Returning to the DJIA 1885 to 1934 chart directly above, the January 1930 -40% flag was a DJIA of 221.92. At the -89.16 level reached in July 1932, the DJIA bottomed at 41.22.
Let's do some Grizzly Bear mathematics using DJIA weekly closing prices:
(41.22/380.33) - 1 = -89.16%
(41.22/221.92)-1 = -81.42%The -40% Rule save the smart money only 8% when compared to someone who bought in at the top. This math is hard!
Currently in the stock market, we have historic low dividends yields on the DJIA, bull market high end P/E ratios in a world with questionable accounting (questionable earnings) and looking at the market with a Bear's Eye View, the DJIA has stayed close to the Zero line for just too long. I personally believe that the DJIA is due for its first real bear market since 1974. As the 1982 to 2000 bull market was such a hot market, for such an extended time, with wide public participation, there is reason to think that a repeat of the Great Depression Bear Market is possible, if not probable. *If* the upcoming bear market repeats the performance of the 1921 to 1932 era DJIA, where the 1932 bottom was actually lower than the 1921 bottom, then the DJIA is fated to fall below the October 1974 DJIA lows of 589.56 by -40%. That would place the bottom of the next DJIA bear market at 353.73!
Am I saying that the DJIA is fated to fall from its January 2000 high of 11,722 to a ultimate low of 353.73, a fall of -96.98? Well I admit that sounds a little extreme, but then the "policy makers" have been working extremely hard since 1974 to make everyone rich by "investing for the long term" in the stock market. So I am not going to say we are going to see a -96% decline, and I am not going to say that we will not as I really don't know what is going to happen. I am only looking back in time to see the range of parameters that the DJIA has moved in past times and a final DJIA low of less than 400 sits at the extreme edge of the possible. After a prolonged bull market that has captured the public's fancy, and finances, the fall can be extreme. I will say that if we only get a bear market with just a -50% decline for a bottom of the next DJIA bear, I think we will be really lucky. I hope we are very lucky as so much rides on the American stock market the world over.
One point I want to make clear, in my opinion the stock market crash of 29-32 did not just happen, nor did a falling popular measure of the American stock market cause the problems of the Great Depression. I believe that the stock market as measured by the DJIA was merely the honest barometer of events brought about by the US Federal Reserve's and other central banks mismanagement of their currencies, and credit, from 1914 to 1929. There is every reason to think that similar conditions exist in today's market. See my piece on "What Happen to the US $20 Gold Double Eagle."
From the 1922 Genoa Conference, the "policy maker" conference that set up the post World War One monetary system, to the Crash of 1929, a significant portion of the excess credit created by the world's central banks did find its way into real estate, commodities and to Wall Street. Buy now pay later credit gave the roar to the "Roaring Twenties." An asset bubble was created by central banking that lured in all too many widows and orphans rent money. You can see the flow of central bank "liquidity" into the stock market in my Bear's Eye View charts by looking the abnormal length of time the DJIA was at the zero line in the charts from, 1925-29. There is no similar long term bull market in the DJIA previous to the 1929 bull market. The 1929 bull market was the second bull market after the creation of the Federal Reserve sixteen years earlier and first bull market after the central banks "policy makers" met at the Genoa Conference just seven years earlier.
After Genoa, much of the discipline of the pre World War gold standard was removed from the world's banking system. Genoa financed the Roaring Twenties and made inevitable the Depressing Thirties. Few people saw what was coming. The expert opinion late 1920's saw a period of everlasting prosperity.
Irving fisher was in the 1920-30's the most influential and well known economist in academia, and Wall Street. His series of economic statistics was published in Barron's every week. As well known then as Alan Greenspan is today, in 1929, Irving Fisher did not see what was coming his way.
One thing that stands out to me when I look at the bear markets of 1929-32 and 1938-42 is that the Central Bankers credit expansions in the 1920's caused more havoc on Wall Street than was caused by the Axis Powers in World War Two. My charts of the 119 years of Dow Bear Markets, either adjusted or unadjusted, speak for themselves. If history is to repeat itself, only time will tell.
Mark J. Lundeen
mlundeen2@mn.rr.com