The Dow(n)

Bristol Palin, teenage mom and first daughter to Alaska Governor Sarah Palin, has broken up with “fiancé” Levi Johnston, according to People magazine. This development contradicts interviews from less than a month ago, when a summer 2009 wedding still appeared on schedule for the pair. Bristol told Greta Van Susteren of FOX News that she and her baby’s father both wanted to get married. Thus, despite the indicators, it appears Palin’s honeymoon is over before it could even begin.

If anyone can relate to this latest episode of teen romantic angst à la Juneau 99801, it is President Obama. Although his approval ratings and popularity remain high, continuing financial woes threaten to steal what small honeymoon Congressional critics from both sides of the aisle were willing to cede him. His political fortunes seem mirrored in the recently volatile and all-too-often plunging Dow Jones Industrial Average.

After a big one-day rally earlier this week, the Dow closed slightly up yesterday, at just above 6,900 points. Unfortunately, for every big gain since last fall, one can point to at least a dozen corresponding substantial one-day drops. What is more, the Dow’s current level is only about half its all-time 13,000+ points high less than a year ago.

Obama has said he refuses to allow the Dow’s daily roller coaster trajectory dictate the direction of his economic policies. The rest of us can only hope his lack of faith in the index turns out correct. The Dow has lost fourteen percent of its value between Obama’s election and inauguration. The only other President who comes close to this is FDR, for whom the Dow fell twelve percent during the same interval.

The Dow then gained a colossal seventy-five percent within the first year of FDR assuming office. A gain of such magnitude is unlikely for Obama in 2009 for a variety of reasons but many voters will look to the Dow for signs of proof that Obama’s stimulus package and other economic policies are working.

As many financial analysts will agree, they could not look to a worse index. The Dow represents a scaled average from the stock prices of thirty large and supposedly highly stable U.S. corporations. Moreover, the impact of any one company on the index as a whole depends more heavily on its share price than its total market capitalization.

Numerous other indices exist that reflect far broader sample sizes and classes of assets, including the Standard & Poors 500, NASDAQ, Russell 2000, Wilshire 5000, Morgan Stanley Capital International, and Shearson Lehman Aggregate Bonds.

In spite of their broader basis, none of these indices is a single ideal market predictor because each tends to focus, consciously or otherwise, on a common factor that makes them insufficiently diverse. For example, the S&P is still mostly larger companies while the Russell is generally small-cap ones. The NASDAQ is heavy on technology companies, while Morgan Stanley and Shearson Lehman, by definition, track only international companies and bonds respectively.

Scott Brown, senior economist with Raymond James Financial of St. Petersburg, is strongly disdainful of using the Dow as a measure for broader economic performance, preferring the slope of the yield curve, the difference between long-term and short-term rates, and the money supply.

Writing in Slate magazine last October, Brandon Fuller maintained the Dow or any stock index is an especially poor measure of the current financial crisis, which results primarily from an unwillingness to extend credit. Fuller argues a measure called the TED Spread is superior because it measures credit conditions directly.

The “T” in TED Spread stands for “Treasury bills” and the “ED” for “Eurodollar contracts,” which are loans between international banks. The TED Spread represents the difference between riskier interbank loans versus loans to the U.S. government. Traditionally hovering at 0.5% or less, the TED Spread jumped to 1.0% in August 2007 and rose above 3.0% by the time of the Emergency Economic Stabilization Act last fall. The reason is all of the toxic assets still held by various financial institutions that make them unattractive to other lenders.

Even Dow Jones & Company states, “It’s not our intention to create an index to shape consumer confidence.” As a measure of stock price performance, the Dow is more a lagging indicator than a leading one.

When the economy begins heading downward, the Dow tends hold its value because it contains mainly blue chip stocks that investors tend to keep in their portfolios to shore them up against bad times.

Yet the reverse is also true. Following the mild recession from 2000 to 2002, the Dow, S&P 500, and NASDAQ were all slower than the portfolios of smart, diversified investors to recoup their lost values.

Still worse, the Dow has twice expanded from its original twelve companies and swapped companies in and out on numerous occasions to reflect their changing fortunes. For example, the Dow bounced Goodyear, Sears, and Union Carbide in 1999 and replaced them with Intel, Microsoft, and SBC Communications. In 2004, Kodak exited in favor of AIG. Altria Group left in 2005 for Bank of America. Today, many believe desperately ailing General Motors is on the way out.

The previous moves took advantage of the high tech and housing bubbles while ignoring the failures of traditional domestic manufacturers. They kept the Dow high but did not reflect the true strength and stability of the U.S. economy, even after the 1990s boom.

The problem here is that many investors are not smart. Driven more by their fears than sound economic analysis, they look for simple, straightforward measures, such as the Dow, to tell them what to do. The dangers of a lagging indicator driving the economy are obvious – it tends to first ignore warning signs and then exacerbate and drag out recovery from downturns.

There seems little doubt the Dow is too entrenched an institution to vanish altogether, even in the transformational economy promised by the Obama Administration. Yet its accuracy in measuring the success of that transformation may require it to change its formula as well as its component parts.

Washington Post columnist Harold Meyerson suggests this morning, “The market fundamentalism to which we've adhered for the past thirty years has – by its own criterion of increasing shareholder value – totally failed.” Per Meyerson, we must adopt “a capitalism more attuned to our national concerns.” Our old manufacturing economy profited from U.S. improvements to infrastructure and education in ways unfelt by our current economy, based on finance and globalization.

While not suggesting full-scale retrograde return to antediluvian industries, Meyerson does maintain, “U.S. ratios of production to consumption and wealth creation to debt creation have gotten dangerously out of whack” and needs correction. Key to this renovation is a promotion of long-term business policies and holding back market pressures for short-term profits of the sort not only expected but also demanded over the past two decades. In addition, corporations must legally answer not just to shareholders but also to stakeholders, including employees and their unions as well as communities in which they operate.

Meyerson notes this form of capitalism requires an investment in upgrading the skills and wages of workers in retail and service sectors, laws easing unionization, and holding such jobs to higher standards and higher value. He also notes it requires “a larger public sector than we have had in recent years.”

Conservatives are apt to label such proposals as outright socialism and the death of the American Dream. Yet as Thomas Frank points out in yesterday’s Wall Street Journal, no Administration was more committed to the concept “government should be market-based” than that of former President Bush. During his Presidency, the number of direct federal government employees shrank, thanks to outsourcing. In spite of this, federal spending grew “pretty significantly” and corruption by contractors ran amok.

To the extent the far-reaching visions of Obama for energy, transportation, communications, and healthcare begin realization, corporate giants such as Boeing, Exxon Mobil, Pfizer, and even General Electric – the only remaining original member of the Dow index – may find themselves joining GM in suffering the fates of the American Cotton Oil Company, Distilling & Cattle Feeding Company, Laclede Gas Light Company, National Lead Company, U.S. Leather Company and other former Dow stalwarts.

The Dow is down, despite all its inherent and premeditated stratagems to buffer itself. That means our economy is not currently working. However, any accurate measure of recovery means it will have to re-invent itself as much as our economy. Luckily, this is one thing at which the Dow has proven itself very good indeed. Let us hope we can say the same for our economy. In Obama’s short honeymoon rests the key to the long-term stability of our Union.