The (Not Very Deep) Meanings of the Dow's New Record

You've got to admire the staying power of the Dow Jones Industrials Average. It was replaced as the best measure of U.S. stock market performance in 1923, when Standard Statistics Co. unveiled its new stock index, which later became the S&P 500 (the Dow was and is simply the crude average of the prices of 30 subjectively chosen stocks). Within the investing business, both the Dow and the S&P have long since been supplanted by the more focused indexes compiled by the likes of Russell Investments and MSCI.

Yet it was the Dow's busting through its all-time record Tuesday that got all the headlines — not the Russell 3000, which surpassed its 2007 peak last month, or the S&P 500, which as I write this is about 15 points short of its record close of 1565.15 on Oct. 9, 2007. (And don't forget the poor Nasdaq Composite, the glamor index of the late 1990s, which is still miles away away from its March 2000 pinnacle.)

It's a remarkable testament to the power of brand, and of habit. (And to having the nation's leading financial newspaper invested in your success for more than a century — although not so much any more.) It's also one that would be pedantic to harp on, given that, despite its flaws, the Dow is sending pretty much the same message as the S&P and Russell 3000: the stock market is back!

Yeah, the comeback is less impressive if you adjust for inflation. But if you factor in dividends, as the Wall Street Journal's Justin Lahart points out, all the gains are restored and then some.

So the stock market is doing great. What exactly does that mean? There are three main ways of explaining stock prices:

The first is basic economics — a share of stock is worth the present value of the future cash flows associated with it. Put another way, a company's stock-market value is a function of how much money investors think it will make in the coming months and years. So a rising Dow or S&P 500 means investors think big American companies will be making more money. Which would be great economic news, except for a couple of things. One is that the link between big-company earnings and U.S. prosperity is weaker than it once was (the corporations that make up the S&P 500 get something more than 40% of their revenue from outside the U.S.). The other, even more important, caveat is that stock market investors aren't reliable oracles. The S&P 500 hit its all-time nominal peak in October 2007, with a global financial unraveling already under way. Investors can miss on the downside, too: "The stock market has predicted nine of the five last recessions," as economist Paul Samuelson liked to say.

A second way to think of stock prices is as a reflection of dynamics only tangentially related to economic value. Wall Street Journal co-founder Charles Dow saw "waves on a beach" in the movements of the average he created; subsequent observers saw all sorts of other, more intricate patterns. For a time this chart-reading was dismissed by financial economists as purest hokum, but it has regained some favor in recent years. Academic research has shown that stock prices clearly exhibit momentum — once they're moving in one direction, they tend to keep moving that way. And when they change direction, they often do so far more sharply than any calmly rational revision of economic forecasts would warrant. So the fact that stock prices are nearing an all-time high could mean that they'll keep rising. Or it could mean they're about to collapse.

Finally, there's supply and demand. Stock prices go up when more people are buying stocks. This could be because they're gung ho about corporate earnings prospects (explanation 1), or that they're mindless trend-followers (explanation 2). But it could also just mean that they have some money and need a place to put it. Right now the main alternative to investing in stocks — fixed-income investments ranging from savings accounts to corporate bonds — is not attractive. Interest rates are infinitesimally low, and because there's simply no room for them to go much lower, the other way of making money on fixed income — by seeing the value of bonds go up as interest rates fall — isn't available. Stocks may be volatile and unpredictable, but at least they can go up. So people buy them. And they go up.

As explanations go, this last one is pretty frustrating: stock prices are going up because people are buying stocks. But it has the virtue of being true, something one can never be sure of with the other two.