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Alan Brochstein, 420 Investor (1,310 clicks)
Contrarian, growth at reasonable price, management change, cannabis stocks
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I shared my bullish views on the market recently, supporting my expectation of a move to 1500 on the S&P 500 this year with some analysis based upon dividend growth last week. I got a great question from "Retired Aviator" asking for my thoughts about the Dow Jones Industrial Average relative to the broader S&P 500. He rightly pointed out that the former yields more and has a lower PE. By my calculation, those advantages are significant, with a dividend yield of 2.4% compared to 1.8% and a PE of 13 compared to 14. Additionally, the DJIA has underperformed SPX by 7% over the past 2 years.

I responded to the question that I didn't have much of a view and that the way the index is calculated is a bit screwy. I decided to spend a little time today digging a bit deeper, and I wanted to share my observations.

For those who are unaware, the S&P 500, which represents the top 500 stocks in terms of market capitalization, is weighted by market cap, like many indices. This means that the biggest stocks count a lot more than smaller ones. An alternative is equal-weighted, and, in fact, Standard & Poor's has an index of the largest 500 companies but equally weighted.

The DJIA is a totally different animal. First, it's only 30 stocks. Second, instead of weighting by market-cap or equally, the higher the price, the more the stock counts in terms of weighting. If a stock splits 2-1, it loses half its impact. The index uses a divisor, currently approximately 0.13, to come up with the overall average. If any stock moves up 1 point in price, it makes the index rise by almost 8 points. Obviously, it's easier for a stock at 100 to go up by 1 than for one priced at 20.

In the table below, which consists of the 30 stocks in the DJIA sorted by price (or weighting), you can see that some stocks count a lot more than others (click to enlarge):

Dow 30 Comparison to S&P 500

As I mentioned, these are all of the stocks in the DJIA. In the first column, I have included in bold-face those that represent the top 10 names in the S&P 500. You may notice that there are only 8. Apple (AAPL) and Wells Fargo (WFC) are among the largest in the S&P 500, but the DJIA excludes them.

In the second column, we have the price. This is used to calculate the weightings that appear in the third column. IBM (IBM) is over 10% of the DJIA, over 10X the weighting of Bank America (BAC) or Alcoa (AA).

The fourth column gives the corresponding weighting for each Dow 30 name in the S&P 500. The sum at the bottom of 31% indicates that the 30 names in the DJIA represent 31% of the S&P 500 (though the weightings are very different).

In the fifth column, I divided the weighting in the DJIA by the weighting in the S&P 500. IBM's counts 6X more in the DJIA than it does in the S&P 500, but there are some smaller components that have even more relative representation. I highlighted those in green. On the other hand, a few are actually underrepresented (noted in red), like General Electric (GE), Pfizer (PFE) and Bank America (BAC). So, while the pundits correctly pointed out that GE was driving the DJIA to a new closing high last week, its move actually had a greater impact on the S&P 500.

Over long periods of time, these indices track each other fairly well. Lately, the DJIA has been recovering some ground it lost as the market was getting hammered in late 2008. As you can see in the chart below, which shows that in the past decade the DJIA has beaten the S&P 500 by 13% (this doesn't include dividends), this isn't exactly an adrenalin-driving trade (click to enlarge):

A Decade of Dow vs. S&P 500

As I contrast the two indices, I come up thinking it might make sense to take some of the implicit bets. My suggestion: With the recent pullback in the Small-Caps (which I wrote about yesterday), try a barbell between smaller stocks and the DJIA to beat the S&P 500. Quite frankly, the Mega-Caps look very attractive in general.

So, the implicit bets one makes with the DJIA would be no AAPL or WFC - not sure about those. Plus, we end up underweight on GE, PFE and BAC, which seems alright. On the other hand, though, we pick up a healthy dose of Big Oil with Chevron (CVX) and ExxonMobil (XOM). I recently doubled my exposure in CVX in my Conservative Growth/Balanced Model Portfolio after snagging some during the summer near 70. My target is 137 a year from now (12PE on 2012 Projected EPS). We own 3 other DJIA names, including Johnson & Johnson (JNJ), Intel (INTC) and Cisco (CSCO). While we don't get as much bang for the buck as we do with CVX, they all have more weight in the DJIA than in the SPX.

While you may not agree with my conclusion that the DJIA might look better than the SPX, I hope you do see how different the two indices appear to be. As I said before, it's probably not going to make or break anyone's year choosing one or the other. I would grab the higher yield and lower valuation and barbell with smaller stocks to create some diversification.

Disclosure: I hold long positions in CSCO, CVX, INTC and JNJ in one or more models at Invest By Model

Source: Dow Jones Industrial Average: Implicit Bets Might Be Smart