Yesterday’s divergence came from a single source: International Business Machines Corp. (NYSE:IBM), which dropped 8% after a poor earnings release that saw sluggish sales in many of its most promising business divisions. Because of the price-weighted nature of the Dow, IBM is often the culprit in situations like this, and yesterday, International Business Machines Corp. (NYSE:IBM)’s drop translated to downward pressure on the Dow of about 130 points, or nearly 1% of the Dow Jones Industrial Average (Dow Jones Indices:.DJI)’s value.
Can you count on the Dow?
Over the long haul, though, the Dow performs much more closely in line with the S&P 500 than you might expect. Last month, Bespoke Investment Group took a look at historical correlations between the two benchmarks over the past 30 years. Analyzing the moves on a rolling one-year basis, Bespoke found a correlation of around 0.97 recently, with the figure having stayed within a range of roughly 0.95 and 0.99 for the past decade.
In fact, the times when the S&P and the Dow Jones Industrial Average (Dow Jones Indices:.DJI) have diverged the most have been when key sectors have had particularly strong or weak performance compared with the broader market. For instance, during the tech bust from 2000 to 2002, correlations between the Dow and the S&P fell below 0.90. That’s because at the time, big tech companies Cisco Systems, Inc. (NASDAQ:CSCO), Microsoft Corporation (NASDAQ:MSFT), and Intel Corporation (NASDAQ:INTC) dominated the broader S&P 500. Yet at the time, Cisco Systems, Inc. (NASDAQ:CSCO) wasn’t even in the Dow, and although Microsoft Corporation (NASDAQ:MSFT) and Intel Corporation (NASDAQ:INTC) had relatively high share prices, their influence was watered down by many old-economy stocks whose market caps were much lower but whose share prices were high enough to give them more weight in the Dow Jones Industrial Average (Dow Jones Indices:.DJI).
By contrast, correlations stayed extremely high during the financial crisis, as the Dow had a reasonably similar weighting of financial stocks to that of the S&P 500. More generally, correlations across even unrelated global stock markets have been increasing lately, as ETFs and other investment vehicles have made it easier to invest across borders and knocked down capital barriers that used to preserve price disparities.
Trust the Dow, but know its flaws
From day to day, the Dow Jones Industrial Average (Dow Jones Indices:.DJI) and other market measures won’t always move in lockstep. But you shouldn’t be overly focused on single-day movements anyway. Over the long haul, the Dow Jones Industrial Average (Dow Jones Indices:.DJI) has generally reflected the performance of bigger groups of large-cap stocks, and that makes it good enough for most casual investors to use as a barometer of the overall market.
The article Is the Dow Broken? originally appeared on Fool.com and is written by Dan Caplinger.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter: @DanCaplinger. The Motley Fool recommends Cisco Systems and Intel and owns shares of Intel, IBM, and Microsoft.
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