Dow might not give you complete picture of U.S. market

[Dennis Ng]

How to Get the Most From the Dow

By Dan Caplinger March 10, 2012 |

For millions of people around the nation, the stock market is the Dow Jones Industrial Average (INDEX: ^DJI ) . The 30 stocks that make up the Dow encompass nearly every industry in the market, going well beyond core namesake industrial stocks to include companies from sectors that no one would ever think of as "industrial."

But if you settle for using the Dow, you're not getting the complete picture of the stock market.

Anatomy of an average
The Dow Industrial Average has evolved over the years. Early in its history, the 12 stocks that made up the average about 100 years ago included largely heavy-industrial companies. As the first member among the current Dow stocks to gain entry to the average, General Electric (NYSE: GE ) was a fair representative of the dozen Dow stocks of the era -- and for the most part, it still is, despite its recent foray into financial services and other non-industrial businesses.

As the average evolved, the Industrial Average in particular expanded in scope to become almost a microcosm of the overall market. Restaurants, financial institutions, and technology companies now play a huge role in the Dow Industrials.

But the Dow still has two glaring omissions: transportation stocks and utilities. Those groups have their own averages to represent them, but keeping them separate means that most investors simply ignore the Dow Transports and Dow Utilities entirely.

The forgotten Dow average
If you want everything the Dow averages have to offer, you have to go beyond the Industrials, Transports, and Utilities to a fourth, often neglected Dow average. The Dow Jones Composite (INDEX: ^DJA ) includes all 65 stocks that appear in the other three averages.

The advantage that the Dow Composite has is that it doesn't leave out any sector of the market. Given the importance of having a broad-based benchmark that reflects the movements in every part of the stock market, the Dow Composite does a better job of providing an all-inclusive snapshot of share prices.

The better Dow?
But the Dow Composite has its own quirks. Since it's a simple average, it's prone to the same price-weighting problems that the Dow Industrials has. And in fact, adding in the Dow Transports and Dow Utilities makes it worse.

Consider: If you add up the share prices of the Dow Industrials, you get a total value of about $1,700. The Transports add up to about $875, while the Utilities weigh in at about $550. Add that together and you get $3,125.

The bigger problem, though, is the relative weightings of those sectors. Even though the Industrials cover nearly all the sectors of the economy, they get just over half the weight of the Dow Composite, while the Transports get a disproportionately high weighting of more than 25%. And in particular, the individual stocks Union Pacific (NYSE: UNP ) and FedEx (NYSE: FDX ) together make up almost a quarter of the Transports' contribution to the Dow Composite. Both companies are reasonable representatives for their respective industries, and they've both performed in line with the economic conditions that they face. But for them to have so much more weight than similar companies in their sector, as well as other sectors that happen to have only a few low-priced stocks in the average, just doesn't make sense.

Good news coming?
Despite its shortcomings, the Dow Composite is confirming the multiyear highs we've seen in many other major market benchmarks. Unlike the Industrials, however, the Dow Composite is somewhat closer to its all-time highs from back in 2007. That's due largely to the transportation sector's contribution to the Composite -- but if the Dow Composite can set new record highs, it could be the first sign of a renewed bull market that could take stocks much higher.