There are three indices global market participants watch closely, whether they are trading in the US market or not. The first is the S&P 500, comprising the 500 largest US-based listed companies across different sectors. You can refer to the earlier post we wrote if you wish to know more about the S&P 500.
The second index is the Nasdaq Composite, which includes more than 3,700 stocks on the tech-heavy Nasdaq exchange. Finally, we have the Dow Jones Industrial Average (DJIA), the focus of today's post. Note that some companies are included in more than one index. Some are even found in all three.
Indices Year To Date Performance
There is a wide dispersion in performance among the three indices so far this year.
The S&P 500 and Nasdaq are up significantly this year, but DJIA is flatlined. This begs the question of whether DJIA is broken. We will examine this, but let's first get a better introduction to the oldest US index.
Origins
The Dow Jones Industrial Average was founded in 1896 by two journalists, Charles Dow, and Edward Jones. It started with 12 industrial stocks, which reflected the booming industries of the late 19th century. As the US economy evolved, the index expanded to 20 stocks in 1916 and 30 stocks in 1928. The index was calculated by simply adding the prices of all the component stocks, divided by the number of stocks in the index. But as more stocks were added and companies went through corporate actions like stock splits, the denominator had to be adjusted to keep the index consistent. Hence, the Dow Divisor was born.
Price-Weighted vs Market Cap-Weighted
Most financial indices weight their component stocks by market capitalization. This means that stocks with a larger market capitalization will move the index more than smaller stocks. Both the S&P 500 and Nasdaq Composite are market cap-weighted. Due to the historical methodology for calculating the Dow Jones Industrial Average, it remains a price-weighted index. This means that stocks with a higher price would have more impact on DJIA, regardless of how big the market cap is. In response to concerns from investors about the price-weighted calculation, the responsible committee has looked at adopting the market-capitalization weighting system. However, they found that DJIA's long-term returns haven't been too different from broader indexes like the S&P 500, so they do not see the need to shift.
Price-Weighted vs Equal-Weighted
As mentioned above, pricier stocks would have more weightage in DJIA. This can skew a certain stock sector's weightage if stocks within that sector have a higher price than the other component stocks. We can see this impact by comparing the sector allocation between DJIA and an equal-weight basket of component stocks.
There is a clear over-weight to Financials and Health Care due to the price-weighting methodology. An equal-weight approach would lead to a better balance between the sectors. This is the advantage of DJIA over the other two US indices. You can easily adjust the allocations to the stock sectors by investing in the 30 component stocks according to your preferred weights. This is difficult to do with the S&P 500 or Nasdaq composite due to the large number of component stocks. You can invest only in a subset of the index but you can get very different results if you miss some of the stocks that subsequently outperform. For example, if you do not own Nvidia and the FAANG stocks, you would not do as well as investing in QQQ, the ETF tracking Nasdaq.
Relative Performance Over Time
To answer the question of whether it is normal for the performance of the three US indices to differ so much, let's look at the historical relative performance of the three indices going back to 1992.
Since 1992, the S&P 500 and DJIA have been roughly moving in lockstep. This confirms the findings of the DJIA committee when they were contemplating a switch in weighting methodology. The Nasdaq, however, has shown a tendency to deviate significantly from the rest. This shouldn't surprise anyone since the Nasdaq is primarily a technology index. It is prone to investor excitement or exuberance over emerging technologies. This is what happened during the internet craze in 1999 which led to the subsequent Tech Bubble crash.
The next time that Nasdaq again outpaced the rest is after the Great Financial Crisis in 2008 when the Fed launched Quantitative Easing. This released a flood of liquidity that powered the imagination of Tech founders (and scammers but that's another story). With no limits to the funding they can get, stories are quickly spun up and sold to hungry investors who are struggling in the low-interest rate environment. This again led to an eventual crash in 2022 when interest rates shot up and liquidity dried up.
However, the story hasn't ended yet. It looks like Nasdaq has found another breath of fresh air from the excitement over generative AI, made popular by ChatGPT. It promises to bring about the next wave of Artificial Intelligence that is smarter and more powerful than before. The beneficiaries so far are again the same old tech leaders plus Nvidia which is selling the chips powering AI machines.
Let's now look at things from another angle. Let's look at the 1-year rolling outperformance of Nasdaq over the rest and also the 1-year rolling outperformance of the S&P 500 over DJIA.
There are two distinct periods of outperformance by the Nasdaq. The first is the Tech Bubble and the second is during the COVID-19 crisis when a huge dollop of liquidity was unleashed by central banks all around the world. Both times, the outperformance was quickly replaced by underperformance before moving back in line again. This pendulum action can be seen throughout the entire period. The only difference is the magnitude of the swings. The S&P 500 also goes through similar swings against DJIA just that the magnitude is much smaller. This is understandable since the S&P 500 is a broader index compared to the Nasdaq Composite.
Risk-Adjusted Performance
We have seen how the three indices can perform differently over time. But which one gives the best risk-adjusted performance? Now that we have the historical price data of the indices, we can easily do the calculations to find out.
As it turns out, the Nasdaq was the top performer in terms of Compound Annual Growth Rate (CAGR). However, this comes with high volatility and a stomach-churning maximum drawdown of 78%. DJIA comes in second place for CAGR but it comes with much lower volatility and maximum drawdown. Ultimately, both Nasdaq and DJIA give the best risk-adjusted return or Sharpe ratio.
Conclusion
With the above analysis, we can conclude that not only is DJIA not broken, but it also remains the most defensive US index during a stock market crisis. And in terms of risk-adjusted return, it is on par with the Nasdaq. However, you can potentially achieve better performance from DJIA by trading the component stocks using your preferred weights rather than the default price weights. You need a lot more capital to do the same for either the S&P 500 or the Nasdaq Composite.
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