The Dow Jones Industrial Average finally broke through the elusive 20,000 point barrier at the market open this morning. Wall Streeters broke out their "Dow 20,000" hats that had been in storage for the past few weeks after the Dow had gotten within less than a point of crossing that seminal number. Commentators on the 24/7 news channels are opining upon the significance of this event and what it portends for the future. There is a great deal of euphoria in the equity markets.
But what does Dow 20,000 really mean?
The Dow is widely followed because it is a vestige of history. It is the oldest index, dating back to the mid-1880s. But the Dow is a highly flawed index. It is not indicative of the broad market, as it is composed of only 30 hand-picked stocks. The S&P 500, on the other hand, is composed of 500 stocks across a wide variety of industries. The stocks in the S&P 500 are not individually selected. Rather, the S&P 500 is composed of the 500 largest stocks by market capitalization.
The Dow is price weighted, meaning that moves in a higher priced stock like Goldman Sachs carry substantially more weight than a lower priced stock like Verizon, despite the fact that Verizon has more than twice the market cap as Goldman. The S&P 500 is weighted by market cap, meaning that larger companies carry more weight in the index. In other words, the S&P 500 is more indicative of average investor behavior.
So, why is Dow 20,000 breaking news?
Simply put, it is significant because people think it is significant. For a brief period of time, this event puts the spotlight on the financial markets. It will likely lead some retail investors to commit funds to the market as people don’t want to miss out on the rally.
But there is a cautionary tale here. The Oracle of Omaha, Warren Buffett, famously wrote, "be greedy when others are fearful and fearful when others are greedy." It would seem that investors coming into the markets because the Dow has hit 20,000 may be a bit on the greedy side.
For several weeks, financial markets have been fixated on the level of the Dow. Over the next several months, investors should instead turn their attention to the Federal Reserve. The next Federal Open Market Committee meeting is next week. While few expect the Fed to hike rates at that meeting, we likely will get further clarity on the likely future path of interest rates. What is clear is that rates will rise in the future. The open question is how far and how fast.
In Invest With The Fed, Gerald Jensen of Creighton University, Luis Garcia-Feijoo of Florida Atlantic University and I found that stocks performed markedly better when rates were falling than when rates were rising. From 1966 through 2013, the S&P 500 advanced more than 15 percent per year when rates were falling but less than 6 percent when rates were rising.
A vintage TV commercial had the tagline, "when E.F. Hutton talks, people listen." Investors would be wise to listen to the Fed, rather than fretting over the stock market level. Ignoring the Fed can be hazardous to one's wealth.
Robert R. Johnson, PhD, CFA, CAIA, is president and chief executive officer of The American College of Financial Services.
The views of contributors are their own and are not the views of The Hill.