The naturally-occurring shifts in investor risk tolerance affect many asset classes but their effects are most clearly and, we believe, most reliably seen in the DJIA. Our belief in the suitability of the DJIA for this purpose is based on the reliability of the algorithms that we developed to anticipate losses in the stock market. Algorithms based on the DJIA are more successful than those based on the S&P 500.
We believe this is because the DJIA:
The S&P stock index has a similarly long history but its construction rules have changed meaningfully since its inception. The number of names has changed from 90 in 1926 to 500 beginning in 1957. The S&P currently uses a strict cap-weighting scheme that periodically reweights all holdings at the same time. In doing so, it tends to assign high weights to sectors that have had unusually strong performance.
We believe other US stocks and stock indexes - such as NASDAQ - are affected by the RTD, but may be relatively more affected by company-specific events and sector trends than is the DJIA. Awareness of the RTD for the DJIA is useful for understanding other stock indexes if one considers RTD condition of DJIA to represent a central systemic condition affecting all US stocks.
Jeffrey Hansen, founder of CPM Investing, was the Director of Consulting for Russell Investments' Tokyo office and was on the team that developed the Russell-Nomura indexes for the Japan stock market. Russell Investments has been a leader in developing stock indexes, such as the Russell 2000. At CPM, we recognize the merits of cap-weighted indexes, particularly the Russell Indexes. However, objective analysis indicated that the DJIA is superior for this purpose.
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