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Is the Dow Broken?

Saturday - 4/20/2013, 5:00pm  ET

Millions of Americans turn to the Dow Jones Industrials as their sole gauge for how well the stock market is doing. Yet a major disparity yesterday between the performance of the Dow and that of the S&P 500 and other broader market measures made many investors wonder just how accurately the Dow reflects the performance of U.S. stocks.

Yesterday's divergence came from a single source: IBM , which dropped 8% after a poor earnings release that saw sluggish sales in many of its most promising business divisions. Because of the price-weighted nature of the Dow, IBM is often the culprit in situations like this, and yesterday, IBM's drop translated to downward pressure on the Dow of about 130 points, or nearly 1% of the Dow's value.

Can you count on the Dow?
Over the long haul, though, the Dow performs much more closely in line with the S&P 500 than you might expect. Last month, Bespoke Investment Group took a look at historical correlations between the two benchmarks over the past 30 years. Analyzing the moves on a rolling one-year basis, Bespoke found a correlation of around 0.97 recently, with the figure having stayed within a range of roughly 0.95 and 0.99 for the past decade.

In fact, the times when the S&P and the Dow have diverged the most have been when key sectors have had particularly strong or weak performance compared with the broader market. For instance, during the tech bust from 2000 to 2002, correlations between the Dow and the S&P fell below 0.90. That's because at the time, big tech companies Cisco Systems , Microsoft , and Intel dominated the broader S&P 500. Yet at the time, Cisco wasn't even in the Dow, and although Microsoft and Intel had relatively high share prices, their influence was watered down by many old-economy stocks whose market caps were much lower but whose share prices were high enough to give them more weight in the Dow.

By contrast, correlations stayed extremely high during the financial crisis, as the Dow had a reasonably similar weighting of financial stocks to that of the S&P 500. More generally, correlations across even unrelated global stock markets have been increasing lately, as ETFs and other investment vehicles have made it easier to invest across borders and knocked down capital barriers that used to preserve price disparities.

Trust the Dow, but know its flaws
From day to day, the Dow and other market measures won't always move in lockstep. But you shouldn't be overly focused on single-day movements anyway. Over the long haul, the Dow has generally reflected the performance of bigger groups of large-cap stocks, and that makes it good enough for most casual investors to use as a barometer of the overall market.

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This article was originally published as Is the Dow Broken?on Fool.com

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