Wall Street breathed a sigh of relief last week when the Dow Jones Industrial Average finally closed above its January 2000 peak of 11,722.98. The index had flirted with the magic level for days before finally setting a new record on October 3, when it jumped 56 points to close the day at 11,727.34. The index went on to set new records three more times, and is now up approximately ten percent on the year.
The celebrations seemed to me to have a cathartic edge, as if the new records closed the door on a tough stretch for America, marked by (among other events) the tech wreck, the September 11 attacks, the Iraq war and Hurricane Katrina. In a downbeat news cycle filled with government sex scandals and school killings in Amish country, the Dow’s high was a bright spot for people to celebrate.
Ultimately, the Dow has rallied over 38 percent since hitting its nadir on October 4, 2002, when it closed at 7,528. Caterpillar, the giant construction company, has been the best performing stock in the index since then; its shares have quadrupled over the past four years.
Missing in the celebrations last week, however, was any real discussion of what the new Dow high really means – what caused it, and what that says about the market. After all, the Dow is a quirky little index, and not everyone fully understands what it represents. I thought I would look a little deeper at the index to see what we are really celebrating.
Not Really “The” Market
The Dow Jones Industrial Average is probably the best-known stock market index in the world (although the good folks at Standard and Poor’s would probably disagree). For many Americans, and particularly for the older generations, the Dow “is” the stock market.
As real indexers know, however, that’s far from the truth. The Dow is one of the most unusual indexes on the market today. The famous benchmark is made up of thirty stocks (up from 12 stocks when it was launched in 1896) chosen from a universe of thousands. Components are chosen by a small index committee, who try to maintain the index as a fair representation of the American economy while limiting turnover. Unlike … well … virtually every other index on the market today, the Dow is “price-weighted,” meaning the total index value is actually a sum of all the individual stock prices that make up the index (the prices are adjusted for countless splits, but the point remains). And free-float weighting? Forget about it.
The limited number of components, committee-selection process and especially the unusual weighting scheme leads to an index that is altogether different from most measures of the market. The following table looks at the weights of the 30 components and how that differs from what their weighting would be under a traditional market-cap weighting scheme.
As shown, the differences between the theoretical market-cap weights and the actual price-weights in the index are substantial. GE, for instance, merits a 9.4 percent weight in the index by market-cap standards, but receives a weight of just 2.4 percent. Meanwhile, Boeing receives a 5.7 percent weight in the index, when, by market cap, it should receive just a 1.7 percent weight. Other companies have smaller but still substantial differences.
One interest facet of the current new high in the Dow is that it represents a relatively narrow rally. Just six of the thirty components are at or near their all-time high: Boeing (NYSE:BA), Johnson & Johnson (NYSE:JNJ), Phillip Morris/Altria (NYSE:MO), Proctor & Gamble (NYSE:PG), United Technology (NYSE:UTX), and Exxon-Mobil (NYSE:XOM). Many others, such as GM (NYSE:GM), Coca-Cola (NYSE:KO) and Merck (NYSE:MRK), stand well below their all-time highs.
The media did not completely overlook the unusual nature of the Dow when it reported on the new all-time highs. A number of media outlets noted that the S&P 500 Index remains 12 percent below its all-time high, and that the Nasdaq Composite lingers more than 55 percent below its tech-era peak. It’s not surprising that the media focused on those two indexes as, with the Dow, they are the three indexes we hear about on our evening news.
If we want to look at the whole market, however, a better measure would be the Dow Jones Wilshire 5000, which contains virtually every stock listed on the market. At first glance, you might guess that the 5000 would be trading at all-time highs as well. After all, small-cap stocks have been performing very well over the past few years (the Russell 2000 seems to set a new record every day), and the Dow is exclusively a large-cap index. To look at the numbers, the Dow has a weighted average market-cap of $126 billion, compared to just $78 billion for the Wilshire 5000. If you add in small-cap exposure, that will only push you higher, right?
Apparently not. The Dow Jones Wilshire 5000 has been performing well recently: the index is trading up 15 percent on the year, and is currently sitting at a five-year high. But it is still eight percent shy of its all-time high of 14,751.64, which it hit back on March 24, 2000.
The fact that the Dow is at an all-time high while the Wilshire 5000 is still eight percent below its peak is all-the-more-remarkable when you consider that the Dow also has a pronounced growth tilt. For instance, the current price/book ratio for the Dow is 3.28, while the Wilshire 5000 rings the table at 2.71. Similarly, the P/E ratio of the Dow is 17.41, while the Wilshire comes in at just 15.80. Value has trumped growth solidly over the past few years, so you would think the Dow's growth tilt would have been a dis-advantage.
Another major difference between the two indexes is their sector weightings. As shown, the Dow Jones Industrial Average is heavily overweight … you guessed it … industrials (and consumer staples), while the Wilshire 5000 has more exposure to financials and energy
This chart reveals a common mis-conception about the current market rally -- it's not only the energy patch that has been performing well.
Musical Chairs and the Next Hot Sector
Of course, the Dow isn’t the only index trading at all-time highs. The Russell 2000 (NYSEARCA:IWM), New York Composite, Amex Composite, S&P 500 Equal-Weight, Russell 1000 Value (NYSEARCA:IWD), various mid-cap indexes … in short, everything but large-cap growth is trading at or near an all-time high. Broadening out, commodities, real estate, gold, emerging markets, many international markets and multiple other asset classes (high-yield bonds, etc.) are trading at peak levels as well.
What’s left out? The answer is obvious: large-cap growth. The Dow setting a new all-time high is a nice milestone, and should be celebrated. But the index represents a very specific and unusual slice of the market. Ideally, we’d like to invite large-cap growth to the party before we really start celebrating the re-birth of the bull market. When that happens, and when the Wilshire 5000 also moves to all-time highs, we can really open the champagne bottles.