FMD Capital Management

Dissecting the Struggling Dow This Year

Written by David Fabian, March 05th, 2014

The Dow Jones Industrial Average (DJIA) is one of the oldest blue-chip indexes in existence.  This bellwether has survived for over 100 years as a time-tested indicator of mega-cap stock performance.  Nearly every investor can easily relate to the name recognition that the DJIA inspires, but few can probably name more than a handful of the 30 stocks that it tracks. 

The index constituents have changed dramatically over the years as new companies are admitted to replace aging monoliths.  The underlying stocks are no longer solely focused in the industrial arena, but instead represent nearly every sector of the economy.  These shakeups can be attributed to technology advancement, social trends, stock value changes, and a host of other characteristics.  However, the one constant is that the index is weighted according to the price of the underlying stocks as opposed to market capitalization or other fundamental qualities.

That means that Visa (V), with a share price of $223, has a larger weighting than Exxon Mobil (XOM) which is currently trading around $94.  The fact that Exxon has a market capitalization that is nearly three times larger than Visa is completely ignored when the index is calculated.

Because of these anomalies, many contemporary investors have dismissed the Dow as an aging relic in the age of cutting-edge index formulation methodology.  In addition, the relatively small subset of just 30 stocks makes it hard to justify as a true sample of the market machinations on a daily basis.  While those arguments may be valid, I believe the Dow does still have some merit in modern investing practice and can be a valuable tool to extrapolate data.

The largest ETF that tracks this index is the SPDR Dow Jones Industrial Average ETF (DIA) which currently controls $11.6 billion.  DIA charges an expense ratio of 0.17% and curiously pays a monthly dividend yield which is rare for an equity-oriented ETF.

As you can see on the chart above, DIA has significantly underperformed high beta sectors such as the iShares Russell 2000 ETF (IWM) and PowerShares QQQ (QQQ) which have both broken out to new highs this week.  The hot money is all chasing growth stocks that offer the potential for superior price appreciation and is indicative of a fully engaged bull market that is seeing money shift away from larger established companies.  Over the last 52 weeks, QQQ has nearly double the performance of DIA.

When you dive deeper into the underlying components of DIA you can get a feel for exactly which areas are dragging it down.  Energy has been weak with Chevron (CVX) and Exxon Mobil (XOM) failing to build any kind of momentum.  In addition, consumer staples stocks such as Proctor & Gamble (PG) and Walmart (WMT) have been moving mostly sideways for the last year while the broader market has rallied.   Even a stock that is beloved as McDonalds (MCD) has been slowly bleeding lower since it peaked in at the beginning of 2013.

The flip side is that the stocks that are seeing the most strength are industrials, consumer discretionary names, and technology companies.  I think that this picture of sector strength and weakness confirms a rotation away from defensive names and into higher risk areas of the market.  If we started to see a pickup in volatility similar to the correction we experienced in 2011, then DIA would likely outperform as money migrates back to a more defensive posture.  The total return of DIA in 2011 was +8.05%, while IWM and QQQ posted returns of -4.43% and +3.47% respectively.  Larger companies are often times seen as safer stocks during periods of prolonged price decline.

The bottom line is that I don’t think you can entirely write off the Dow as a piece of history.  Instead, it can be used as an important gauge of the strength of large companies during periods of exuberance and pessimism.  In addition, it provides a long-term historical frame of reference from which we can look back at decades of market price data that tells a colorful story.

Looking to boost the yield of your portfolio?   Download our latest strategic income special report here.