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Monthly Discussion

Forecasting the DOW via the Divisor - Revisited

In the September 16, 2002 issue of this newsletter we forecasted the DOW in a different way, via the divisor. Today we look again at this approach zooming into a little more detail.

The average price of the 30 DOW industrials is the main ingredient in the calculation of the DJIA. Interestingly this number does not change significantly over time! An endless stream of stock splits has kept this number more or less constant over decades. It was the corresponding decrease of the divisor—also involved in the calculation of the DJIA—that was responsible for the impressive growth of the market over the second part of the 20^th century.

Forecasting the Dow via the divisor was first treated in An S-Shaped trail to Wall Street and later updated in this newsletter. The method is rather crude but our forecast of more than two years ago proved not so bad after all, see Exhibit 3.

Exhibit 3. The graph is adapted here from the newsletter issue of September 16, 2003. The purple line is the forecast as published in September 16, 2003. The white dots show the subsequent evolution of the DJIA.

Today we will focus in a more recent historical period during which the market seems to have settled down to a state of “not much happening”.

For the calculation of the DOW JONES industrial index a simple arithmetic average price of the thirty industrials is divided by the famous divisor. In Exhibit 4 we show how this index has evolved over the last 15 months. But another average price can be obtained as a ratio of the thirty industrials’ exchange dollar volume divided by their exchange share volume. This is an average price weighted by the share volume and reflects more accurately the prices favored by investors during the day. Just think of the fact that a little-traded high-priced stock influences significantly the arithmetic average, unjustifiably so, if this index is supposed to reflect the day’s market activity and investor trends.

Both calculations of the DJIA price result in generally horizontal trends, see Exhibit 4, 3^rd graph down. The weighted price (yellow) line is even flatter than the arithmetic one (blue line). In fact, the rise of the DJIA that made headlines during the month of November 2004 is not corroborated by the more “truthful” weighted price. There is corroboration of this rise by the share volume and the dollar value, see Exhibit 4, 1^st and 2^nd graph, but this rise “evaporates” when we take the ratio dollar volume to share volume (yellow line).

The horizontal character of all graphs in Exhibit 4 is striking. A 90-day moving average is superimposed on each graph to better outline the trend. The top graph labeled “true” share volume shows the share volume of the 30 industrials after corrections for splits. The trend is generally horizontal but shows a rising tendency in the last three months. Similarly, the dollar value exchanged over the 30 industrials, flat horizontal for the most part, rises gently in the last three months. The ratio of the two volumes gives the yellow line in the 3^rd graph, which is a trend utterly horizontal since June 30. The arithmetic average (blue line in 3^rd graph) shows a rise in August, a decline in October, and another rise in November, but all this activity, as much as it may provoke agitation in the stock market, it is rather meaningless in terms of what is fundamentally going on, which is not much!

As for the divisor, 4^th graph, its trend is rock stable. A safe bet is that it will continue like this for a while because no company seems ready to split its stock in the near future.

CONCLUSIONS

One needs no fancy forecasting techniques to predict that the share volume and the dollar value of the DJIA will continue roughly on their horizontal course. With more confidence one can say that their ratio (the weighted DJIA price) will continue its horizontal trend. With still more confidence, one can assert that the divisor will continue its horizontal trend. And there you have the forecast for the DJIA, horizontal! Undoubtedly there will be short-term rises and declines of the arithmetic average price that will reflect upon the daily DJIA, just like those we saw in August, October, and November. But you can be sure these excursions will “arrange” themselves so as to stay on a horizontal longer-term trend.

Exhibit 4. The smooth lines in the top three graphs represent 90-day moving averages. The yellow line is the most realistic representation of the average price as defined by investor activity.