The Hitchhikers Guide to the DOW
- Nov 13, 2006
- admin
- Investing
“BRING OUT THE GIMPS!”
You know the types of people I’m talking about.
The financial “gimps” that CNBC and other financial news stations pull out every time the market hits a new high or trades sharply lower.
The ones with the crazy, unsettled eyes who try as hard as they can pull off the “eccentric” look by wearing “Einstein-type” J-Fro’s and pausing before answering any question.
Yeah, those nuts…
After years of wandering the financial desert, it seems like the DOW’s recent rally to new highs has brought them back from the brink, wild predictions about the bull future readily in hand!
Today’s topic: Dow 36,000.
Yes, Dow 36,000….rarely has there been a sequence of numbers that rolled off my tongue as easily, as naturally as “36,000.” It almost makes me feel so, well, Nikkei-ish!
But I would advise waiting a moment before uncorking the champagne. In fact, I would suggest cracking open a beer to curb your enthusiasm (and maybe even a light beer at that).
As usual, the headlines are almost enough to make many an investor reach out and touch someone in giddiness: aided by declining oil prices, the Dow Jones Industrial Average reached record highs this month, the latest sign that investor sentiment is recovering from the bear market of 2000-02.
Putting the Dow’s Recent Move in Perspective
Sure, the rising tide of a rising market lifts all boats. But keep in mind that there’s still a long way to go; the much broader S&P 500 index is 12% below its peak, and the NASDAQ composite is less than half its high.
But there are other reasons why the Dow breaking new highs isn’t as important as it once was. Why? Because the Dow has become a shadow of its former self, a relic of a stock market indicator.
Let me explain.
When discussing the Dow, most people mistakenly believe that the main reason it’s outdated is because it only represents 30 (of roughly 10,000) American stocks.
But that argument isn’t as strong as it may seem. As you can see in the table below, the 30 stocks that make up the Dow are far and away the largest companies by sales and profits in their respective industry groups.
Companies that dominate their industry groups usually account for at least 20% of all the sales/profits of that group. Furthermore, the companies that make up the Dow represent a wide variety of large and important industry groups.
Although the total amount of companies is small on a relative basis, the fact that you have 30 of the largest companies in America representing 30 of the largest industry groups in America makes the Dow a valuable tool for getting insight into the performance of marketable equity securities.
The “Price-Weighted” Issue
By far the most widely used – and most credible – knock on the Dow however, is that it’s a “price-weighted” index as opposed to a “value-weighted” index. That gives higher-priced stocks more influence over the average than their lower-priced counterparts.
For example, during one period last month I watched as shares of construction-equipment maker Caterpillar (SYM: CAT) moved smartly higher, rising from $60 to $70 per share (and consequently falling again).
During the same time however, shares of General Electric (SYM: GE) have traded down slightly from $36 to $35.
Since the Dow is price-weighted the effects these two stocks have on the performance of the market can be misleading: every $1 increase in Caterpillar moves the market more than every $1 decrease in General Electric simply because the price of the stock is higher.
But that becomes absurd when you realize that General Electric’s market value dwarfs Caterpillars by a factor of 8 ($366 billion to $45 billion). Had the Dow been value-weighted instead of price-weighted, General Electric’s downward trading pattern would have likely weighed so heavily on the Dow that the market would not have hit new highs.
Don’t Call it a Comeback
But maybe the resurgence of the Dow is nevertheless revealing a shift in the structure of the stock market itself. In general, big cap stocks both here and abroad are finally making a comeback.
Since the dotcom bubble burst it’s been small cap stocks that have led the charge.
The Dow Jones Wilshire Small Cap index reached its record high in May this year and is 19% above its March 2000 level. But as you know, the equivalent large-cap index has been, for the most part, stuck in the mud since 2000.
As a result, the advance of the stock market from its late 2002 low to now has been extremely broad. In fact, most stocks in the S & P 500 have actually outperformed the index in each of the years from 2000 to 2005. At last this year the trend has begun to change; a slight majority of shares have underperformed the index.
The Real Reason the Dow Has Moved Higher
As I discussed recently in the Tycoon Report, the markets recent move upward has far less to do with company fundamentals then it does with human nature.
As ironic as this may sound to you, the real reason the market’s been going higher has been the expectation of an economic slowdown…
That fear prompts investors to seek the safety of large, multinational groups, with a spread of products and operations that confers some protection from any economic fall-out.
In addition to “protection” there is a case, albeit a very small one, to be made for “compressed” valuations in large-cap stocks:
Back in August 2000, the most highly valued 20% of the American stock market traded on a prospective price/earnings ratio of 57.4, compared with just 7.7 for the bottom 20%.
By July of this year, the respective multiples were just 27.4 and 9.7. No longer do investors have to pay such a big premium for quality.
The bad news for most investors is that most active money managers struggle to outperform the index when large-cap shares are doing well.
In your case though, you may feel secure: it is in smaller stocks – which are more poorly researched – where the best opportunities for bargain hunting can usually be found.
And that means we should continue to do well together here at Fallen Angel Stocks.
Have a Great Month,
Dylan Jovine