Trading the Dow: What History Tells Us

In my last post about various 'Dogs of the Dow' strategies, I outlined the potential for market beating stock picks through the identification of depressed Dow stocks. The general idea is that this forced contrarian strategy is a good way to induce all too often over optimistic investors to truly buy low and, hopefully, sell high.

This efficacy of various Dow underdog strategies is hard to prove over a long period of time. But, the idea that the Dow offers a risk averse entry to the stock market.

As you can see, the Dow Jones Industrial Average since 1950 has provided a .3% lower annualized return than the S&P 500 over the last half century with 9% less volatility and lower downside deviation. (You can learn to calculate these metrics in my series on Portfolio Performance Metrics.) So, while the Dow Jones has underperformed the S&P over the last 50 years, it has provided a modicum of “safety” for those looking for less volatile year-to-year price movements.

But, why should you buy the Dow today? First and foremost, the Dow Jones’ indicated dividend yield is currently almost 4.0% whereas the S&P 500 offers just 3.3%. This provides some level of cushion as you wait for the markets to turn around. More importantly, if history can be our guide, you won’t have to wait long for an eventual rebound.

click to enlarge

Since 1928, the Dow Jones has posted just 28 down years with five sets of sequential down years. Implying that, over the last 80 years, there have only been 19 year plus periods in which the market destroyed value. In 65 of the last 80 years, there have been positive returns. More importantly, years following a >20% decline averaged a 26.1% rebound. This is not enough for those who bought before a decline to be made whole, but provides a very intriguing possibility for those of us with capital after a major market disjunction. (Data from Data360.org)

For more on the bull case for the Dow, check out this analysis provided by Ned Davis Research. This analysis shows a renormalization of price dividend ratios which have been shown to be the best long-term predictor of, overall market performance. While we may still seem to be “overvalued” based on this metric, remember that shareholder returns have shifted towards share buybacks over dividends in the last decade, which has inflated price dividend ratios. Furthermore, realize that indicators rarely trade without hesitation from overvalued to undervalued. While there is a case to be made that the Dow may stay range-bound for years as dividends catch up to pricing and bring us back within historical valuation levels, intermediate rallies are very likely. For those with a longer-term outlook, increasing dividends will only improve yield on cost.

If this article has piqued your interest, you can trade the Dow Jones Industrial index using ETFs such as iShares Dow Jones U.S. Industrials (IYJ), Dow Diamonds (DIA), and the Ultra Dow (DDM, provides 2x exposure). There’s even a Dogs of the Dow ETN (DOD), which unfortunately debuted just over a year ago.

Full Disclosure: No positions in the stocks mentioned at the time of writing.

Comments

[wolfdog:]

I have just completed a projection of what DOW dividends will be for '09. It is highly likely that the dividend paid will decline yr/yr owing to div cuts at BAC and C. And possible cuts at AA and JPM. And GM's div decline as well although now that GM is almost a microcap stock, the keepers of the index have a big decision to make, does GM stay in or go?

Based on my estimate, DOW div will decline about 6%. And I calculate the current yield at 3.6%, which is somewhat less than the near-4 mentioned in this article.

But the more important issue is that it looks like the trend of the DOW div yield is inexorably up, since bottoming in 2000. If we are lucky, the yield will stay range bound as the author suggests, between 3 and 4% as was the case 1960 - 73. More ominously, and the case I favor slightly at this time, the yield will march higher toward 5 or even 6% over the next several years.

What could cause this? Investor repugnance toward equities after this brutal bear market. It takes a long time to reprice assets at inflection points, and now we have the reality that competition from non-Treasury instruments provides very attractive, albeit somewhat risky, yields. Moreover, notwithstanding the Fed's quantitative easing manipulation of the long end of the T-curve, how are we going to finance these massive deficits over time unless interest rates are eventually allowed to float much higher? That is, foreign investors who finance the U. S. could decide to go on strike, especially if the dollar weakens over time. Just as our goal should be higher self sufficiency in energy, we should also devise policies to enable the Federal deficit to be financed in a greater proportion from domestic saving. Only two avenues seem viable to accomplish this: tax incentives or higher interest rates.

Thus, the combination of investor demand for higher income and/or less exposure to volatile equties plus the carrot of higher competitive yields from bonds (and I need to mention how does all the TARP money attract private capital to get re-fied 3 years down the road?) seems likely to create pressure on stock valuations leading to higher yields. At some point this will put a floor on stock prices and create a historic secular bear market low.........but investors need to be thinking about the notion that we are not there yet.

Jan 21 01:28 PM

[The Curious...:]

Very good analysis and I like your more bearish argument in response to my post. I was trying to allude to the possibility of a longer term but I do believe that we'll see rallies in between which makes the Dow an interesting play both as a trade and a long term investment though with varying entry points depending on your personal investment horizon.

Also, I'd like to add a correction (as I seem to be doing a lot these days... must get better at proof reading), I mention that the Dow has traded up in "65 of the last 80 years" it should read "65% of the last 80 years."

Jan 21 02:08 PM