By Martin Wolk Executive business editor
msnbc.com
updated 10/19/2006 6:55:05 PM ET 2006-10-19T22:55:05

This story is an updated version of a story that originally ran in January 2006.

After meandering for much of the year, U.S. stock markets have been on a roll since midsummer, pushing to their highest levels in years, at least partly on optimism that the Federal Reserve is done raising rates and the economy is continuing to expand.

Major Market Indices

Investor enthusiasm also has been boosted by a series of record highs for the Dow Jones industrial average, which closed above 12,000 Thursday for the first time ever.

The buzz created by the Dow’s big day raises the question: Why does this idiosyncratic and flawed index — composed of just 30 stocks hand-picked by editors at The Wall Street Journal — continue to hold such a grip on the popular imagination?

It is hardly the most representative index available to assess the U.S. economy or stock market, nor is it used much by professionals or individuals to guide investment decisions.

Yet the Dow’s storied history, great brand name and unmatched 110-year track record still make it the best-known U.S. market indicator.

“It’s just embedded,” said Liz Ann Sonders, chief investment strategist for Charles Schwab and Co. “The media and broad public, Main Street, still see the Dow as the market.”

Because of the Dow’s relatively narrow focus, it long ago fell out of favor among professionals, who generally use the broader Standard & Poor’s 500 as their main benchmark.

The Dow industrials account for only 25 to 30 percent of the nation’s total market capitalization, compared with 80 percent for the Standard & Poor’s 500 and 98 percent for the Russell 3000, another well-known broad index.

And while the stocks in the S&P 500 also are hand-selected — by a committee of analysts —the approach is much more scientific. The membership of the S&P 500 literally is reviewed daily as analysts seek to make sure the weighting of the index closely reflects the industry makeup of all stocks traded on major U.S. exchanges, said Howard Silverblatt, a market equity analyst at S&P.

For example if banks make up 20 percent of U.S. market capitalization, the sector will have the same weighting within the S&P 500. And if regional banks are 5 percent of the total, that will be reflected as well.

“The aim of the S&P 500 is to emulate the entire market, not necessarily do better than the market,” Silverblatt said. “If we beat the overall market, we’re not doing our job.”

Standard & Poor’s is so good at what it does that hundreds of investment funds do nothing more than mimic the S&P 500 by maintaining a basket of stocks equivalent to the weighting determined by the S&P committee.

All told about $1 trillion in securities are “pledged” to track the S&P 500, Silverblatt said, compared with just $40 billion that follows the Dow 30 through securities such as the so-called “Diamonds,” an exchange-traded fund.

The vast amount of money riding on the S&P 500 explains why individual share values can rise or fall significantly when a stock is added to or deleted from the S&P 500.

That is a fairly common occurrence. Stocks are are replaced about twice a month in the index for an annual turnover rate of about 4 percent, keeping the S&P relatively current. In recent months, for example, the index has added Whole Food Markets, Amazon.com, and Public Storage, eliminating companies like May Dept. Stores, Delta Air Lines and Toys ‘R’ Us.

The editors who oversee the Dow are far more deliberate.

Dow Jones, parent company of the Journal, hasn’t made a change to the index since April 2004, when it added three companies: insurer American International Group, pharmaceutical giant Pfizer and telecommunications provider Verizon Communications. They replaced fading giants AT&T, Eastman Kodak and International Paper.

(The AT&T name recently got back into the index through a back door after the company was acquired by SBC, which then changed the name of the merged company to AT&T.)

Prior to that the Dow had not made a change to the industrials since 1999, when it added four companies, including its first Nasdaq-listed companies: Microsoft and Intel. (MSNBC.com is a Microsoft-NBC joint venture.)

“It does not include new firms easily,” said Jeremy Siegel, a professor at the Wharton School and author of “Stocks for the Long Run.” “It represents what I would call seasoned firms that have a good long history.”

Despite its industrial-sounding name, the Dow includes financial service providers, telecom firms and retailers although it is weighted toward the industrial sector. For a complete list of Dow components, click here.

For all the due deliberation of the Journal editors, the Dow tends to track the broader market fairly well, although its relative paucity of tech stocks meant that it missed much of the market’s boom of the 1990s — as well as its later collapse.

Last year the Dow lost 0.6 percent, while the technology-heavy Nasdaq composite index gained 1.4 percent and the S&P 500 gained 3 percent.

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