All Eyes On The Dow: 20,000?

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All Eyes on the Dow – How Meaningful is Dow 20,000?

With markets roaring back after the election, clients have been glued to their televisions, watching the Dow Jones Industrial Average make its ascent toward the “touchdown mark” of 20,0001.  It makes us feel good to see US stocks rally to finish off the year on a high note and in such a robust fashion.

Although we are thankful for our clients keeping abreast of market levels and wondering how they might impact their portfolios, we hope to give a bit of clarity so you, as an investor, are a better-informed consumer of financial information2

Q: The Dow Jones Industrial Average (DJIA) is at all-time highs and could soon break 20,000! That must mean something! Should I buy in or sell out at this point!?

A:  I would offer a word of caution to investors here and suggest that they see this as a reminder that the market has come a long way, but not necessarily as an indicator of a need to make large changes your portfolios. History has shown that timing the market based on a barrier being broken has been a losing proposition for investors. The market giveth and the market taketh away. It is very hard in the short-term to define WHEN either of those outcomes will occur.

As investors focused on risk management, we maintain a consistent process that focuses on capturing as much of the market gains as they come, and protecting some portion of the downsides when the market draws back through a balance of diversification (holding investments that act differently in various market environments), rebalancing (re-aligning the asset mix when it deviates from its risk objectives) and active management (expertise in investment process and implementation). Changing the mix of assets is warranted when your individual needs as an investor changes, not when the financial news media is hyping a new high for the DJIA.

Q: The US stocks in my portfolio were down several days in a row when the Dow was up. What gives? Why are you underperforming the market on those days?

A: This gets in to an interesting conversation. Since the election, the DJIA and S&P 500 have gone different ways (one up for the day while the other was down) 8 times in the 25 trading days since the election (32% of the time!). There are a few reasons for this, and it comes down to how indices are constructed.

The Dow Jones Industrial Average is a price-weighted index of 30 large companies whose inclusion is decided by editors of the Wall Street Journal3. It needs to be adjusted for things such as stock splits, and other implications that affect the listing price of a stock. Most other indexes are capitalization-weighted indices (including the S&P 500), meaning that the inclusion of any given company is due to the value of outstanding stock shares. When we talk about “the market” in our everyday speech, my feeling is that the capitalization-weighted indices are what we should be talking about. For example, in US stocks, one can choose from a long list of indexes that track the “natural market” such as the Russell 3000 Index, S&P Dow Jones Total Market Index, MSCI US Broad Market Index, CRSP US Total Market Index, etc. The products that go into our portfolios are based on strategies benchmarked using capitalization-weighted indices. Therefore, they are a better indication of what is occurring in the equity component of your portfolio.

Generally, these two index types (the Dow Jones and the S&P 500) tend to move similarly over time (moving in the same direction on a given day 90% of the time over the last 10 years…they are both comprised of US stocks, after all), but there can be notable differences. Since the companies currently in the Dow are only 30 of the several thousand US stocks, representing around 22% of the US market capitalization (and therefore ignoring the other 78%), they do not consider the other large-, mid-, and small-companies that make up the US markets. Also, the impact of many of these stocks is magnified significantly. The most recent example of this is Goldman Sachs (GS), which is the highest price stock in the Dow (at last check around $245/share). This gives Goldman an 8.3% weight in the Dow Jones index. The top 3 names by price Goldman Sachs (GS), 3M Corp. (MMM) and IBM Corp. (IBM) represent 20.24% of the DJIA’s exposure. Based on their size (market capitalization), those same 3 companies are 1.76% of the S&P 500. This multiplies their impact on returns by over 11.5x (GS is the smallest of the three, with ~0.4% of the S&P, but its impact on returns in the DJIA is magnified 20.75x – it accounted for around 1/3 of the climb from 19,000 to ~20,000 on its own).

So, the DJIA is not what I’d prefer to call “the market” even though it’s interesting to look at. My personal opinion is that financial media prefers to focus on it for purposes of sensationalism, as the tag line “Dow at -500 points or +230 points” grabs people’s attention more than “S&P is -56 points or up +26.2 points” even though those represent the same moves on a percentage basis.

That being said, it’s always fun to recount where you were when the Dow hit a milestone

 

1 Interestingly enough, the S&P 500 just recently crossed a notable threshold of $20 trillion in market capitalization. 2This discussion is focused on equity (stock) indexes only, so it is not likely comparable to a portfolio that has multiple different assets such as bonds, cash, real estate, and other alternatives. This implication will likely be addressed in a future blog post.
For those interested in some not-so-light reading, there is an interesting paper by Harlan D. Platt, Licheng Cai, and Marjorie A. Platt in the The Journal of Index Investing (Spring 2014, Vol. 4, No. 4: pp. 43-52) entitled “Is the DJIA Biased?” To understand more of their findings, please go to http://www.iijournals.com/doi/abs/10.3905/jii.2014.4.4.043

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Matt Underwood, CFA is the Investment Strategist and Portfolio Manager at Patriot Wealth Management in Raleigh, NC. Matt is a Chartered Financial Analyst® (CFA®) charterholder and member of CFA Institute, the CFA Society of North Carolina, and the CFA Society of Phoenix. He holds an MBA from the Eller College of Management at the University of Arizona.

CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute

This article is an expression of Matt Underwood’s personal opinions and insights. It should not be construed as customized investment advice for any single individual. To fully understand how these insights may apply to your specific situation, please confirm with your own primary research or consult directly with a financial advisor.

 

*Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance. Past performance does not guarantee future results. Consult your financial professional before making any investment decision.

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