All follow the Dow but maybe we should watch Caterpillar. A look at how 1 firm rules the index

Is it time to ditch the Dow? The naysayers’ case.

NEW YORK — It’s Caterpillar’s market.

The Illinois maker of earth movers is just one of 30 companies in the Dow Jones industrial average, but you wouldn’t know it from its impact on the index recently. Caterpillar’s stock is responsible for 40 percent of the Dow’s climb since the beginning of the year.

Translation: If not for Caterpillar Inc., the world’s most widely followed stock index would be up just 2.5 percent this year instead of 4.1 percent. Take out gains from the next three biggest contributors to the index — McDonald’s Corp., DuPont Co. and Boeing Co. — and we would be sitting on losses.

“It’s all about Cat,” marvels BNY ConvergEx strategist Nicholas Colas in a recent report. “Names like Microsoft, Cisco, Bank of America and Intel might be large companies but as far as Dow impact goes, they are tiny.”

Caterpillar is one of the great American success stories coming out of the recession. Sales of its loaders, excavators and harvesters jumped 37 percent in August, much of that thanks to demand abroad. So if you like to cheer on the Dow now that it’s risen for a fourth week in a row, news that Caterpillar is the pied piper of those gains should make you happy.

Just don’t confuse the Dow with the stock market or the economy.

Notwithstanding our attention to its every rise and dip, the Dow has a big flaw that explains its top-heavy nature. The index gives greater weight to high-priced stocks than to low-priced ones.

You might think investing $30 in a mutual fund tracking the Dow means $1 is riding on each of the 30 stocks. In reality, the higher the price, the more of that $30 is allocated to that stock. Stock in Caterpillar closed Friday at $79.73 a share — more than four times the price of General Electric Co. or Intel Corp. That means if you put money into a mutual fund tracking the Dow, more than four times as much of that money will end up in this one stock than in GE or Intel.

Now consider that this buying could raise the price of the stock, begetting more buying. So, as Caterpillar was leaving other Dow members in the dust with a 40 percent rise this year, more and more of each new dollar in the index went into this manufacturer. In fact, a fifth more of your money is going into Cat now than it would have at the beginning of the year.

Meanwhile, the stock has gotten expensive, too. It trades now at 20 times estimated earnings this year versus 13 times for the average Dow member.

Of course, you should really do the opposite: Buy more when stock is cheap.

All this would be mere curiosity if so much of our mood and money didn’t seem to hang on the Dow lately. When the index is up, we’re up. When it’s down, we’re down. The question now: With the recovery in doubt, will the index confirm our hopes that better times are around the corner and continue to climb?

In no small part, the answer is rather prosaic. Check back on Oct. 21 when Cat announces earnings for the third quarter. Analysts are expecting a profit of $1.07 a share, more than double what it reported a year earlier.

The distortions of the Dow also matter because of the way we’re now investing. After two crashes in a decade, individual investors are pulling money out of stocks. For those sticking with equities, there’s an equally interesting shift in where we’re putting our money: mutual funds tracking equity indexes with computers rather than funds run by highly paid stock pickers.

There are many indexes beside the Dow, of course. One that gets much more of our money is the Standard & Poor’s 500. It allocates dollars according to a company’s market value, or the stock price multiplied by the number of shares. The S&P also spreads its bets over 500 stocks so there’s less risk of a single soaring stock bringing down the index if it stumbles.

But the S&P suffers from the same self-reinforcing ill of the Dow. As the market value of a company rises, S&P index funds buy more of the stock, lifting the price.

As tech stocks rose in the late 90s, index funds pushed them higher still. Ditto for financial stocks before the last crash. Instead of protecting us from our all-too-human swings from greed to fear, the computers running the index funds exaggerate them.

One index that tries to fix this problem is the PowerShares FTSE RAFI 1000. The index was designed by Research Affiliates, a money management firm run by famed S&P critic Robert Arnott. Instead of dividing money according to market values, it does so based on a company’s cash flow and other fundamentals. PowerShares is down -5.44 percent annually over three years, but that is 2.15 percentage points better than the S&P.

The flaws of our most popular indexes aren’t new.

They started when Charles Dow listed a handful of big stocks and their prices on a piece of paper and decided we should buy one share of each instead of multiples and fractions of those shares so our money and risk would be equally divided among the companies. His original sin should have doomed the measure but for one thing: He did this in 1896.

Of course, old brands die hard. We’re drawn to them despite ourselves.

“You can get some distorted results,” says Harris Private Bank strategist Jack Ablin of the Dow, though he concedes, “I still follow it.”

ConvergEx’s Colas rips into its price-weighting as “arbitrary” but in the next moment is talking excitedly about how the index is older even than that most venerable symbol of American capitalism, the New York Stock Exchange Building (erected in 1903).

And so warts and all, the Dow will continue to shape our views.

“It influences our perception of the economy,” Colas says. “And right now perceptions matter.”