DJIA Flirts with a Record Close

30 Sep

If you’re like me, you watch CNBC for individual company and stock market news. It can prove valuable when news is breaking and for real-time market data. Yet despite its virtues, CNBC has a short-term focus which is why it is almost equally as valuable while muted. It is arguably the most-watched financial network and this position gives it considerable influence on investors of all types, both professionals and novices. Yet this kind of short-term thinking can be dangerous in a game that is best played over the long-term.

This week, even on mute, it seemed like they were covering a horse race, not the stock market, as the Dow Jones Industrial Average (DJIA) neared its record close set back in 2000 (the S&P 500, by the way, has over 14% higher to go to best its all-time closing high of 1527.46). Case in point, CNBC added along the top of the screen a “DJIA within X pts of record close” banner and had the “breaking news” alert going during market hours. Meanwhile, guests were asked if and when we’ll get to that record close.

So what if the Dow nears its record close?! It accounts for only 25% of the broad market (as measured by the Wilshire 5000) and is composed of just 30 companies in the form of a price-weighted average. To calculate it, the 30 companies’ stock prices are literally added together and divided by, as of today, 0.12493117. That gives us the index value seen every day. This means companies with the largest absolute prices in the index have the largest relative impact on performance. For instance, IBM, with an $82 price would have a larger impact for each percent move than Intel, with a $20 price. A 5% move for IBM is $4.10, but just $1.00 for Intel. Similar problems exist for market-value weighted indexes, such as the S&P 500 (which is now float-weighted). These types of indexes tend to underweight undervalued stocks and overweight overvalued stocks, the exact opposite of what should be done.

Forgetting all that for a minute, the DJIA has had a strong run in recent months. Over the longer-term the performance of the DJIA tends to approximate the broader markets, but year-to-date the Dow is above the S&P 500 by nearly 2 percentage points, and has had its best quarter since the third quarter of 1995. How to play this recent run-up? If you own Diamonds (DIA), now might be a good time to sell at-the-money or slightly out-of-the-money call options on your shares. Going out to December or January, you’ll earn a decent premium and are likely to have the chance to buy them back at cheaper prices before expiration.

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