DIA: Mid-Year Performance Review And Outlook

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About: SPDR Dow Jones Industrial Average ETF (DIA)
by: BOOX Research
Summary

DIA is up 15% year to date following the strongest month of June in 80 years where the underlying index climbed 7.2%.

The impressive gains this year represent a rebound from the deep losses last December, while the ETF is flat compared to highs set in early 2018.

A number of stocks in DIA now appear expensive based on valuation multiples well above historical averages.

A complex macro outlook including conflicting messages regarding the direction of interest rates and concerning trends among global growth dynamics warrants a sense of caution in the market.

The SPDR Dow Jones Industrial Average ETF (NYSE:DIA) is the exchange-traded fund that tracks the historically important index with 30 constituents. The price-weighted methodology of the DJIA is something of an outlier among modern indexes and funds, as the more common market cap weighting is understood to be more equitable and intuitive. In the Dow Jones Industrial Average, the weighting favors shares with a higher nominal price. For this reason, Boeing (NYSE:BA), trading at $350, has the largest weighting in DIA at 8.9%, even though its market capitalization is one-fifth the size of Microsoft (NASDAQ:MSFT), which only represents 3.5% of the index and ETF. Investors here are buying a collection of "blue-chip" stocks that are recognized as a barometer for stock market performance. DIA is up 15% in 2019 and 10% over the past year on a total return basis, in what has been a volatile period. This article looks at the performance of the underlying stocks in DIA with a market outlook for the second half of the year.

2019 Macro Recap

It's been a strong year in the market, although the large percentage gains are relative to prices that ended 2018 at depressed levels. Even as DIA is up 15% year to date, the price level is about flat compared to what was then an all-time high set in January 2018. In other words, the market hasn't returned much in over 18 months. The story has been largely better-than-expected economic growth over the past year, coupled with strong earnings that has been met with skepticism among investors. In Q4 2018, broad market indexes, including S&P 500 (SPY) and the Dow Jones Industrial Average, briefly approached bear market conditions as concerns were raised regarding the trajectory of higher interest rates with data pointing to weaker growth globally. The other wrench in the outlook has been recurring trade dispute tensions among the U.S.-China that remain unresolved.

This year, more dovish monetary policy signaling by the Fed has lifted markets, which have also been supported by solid corporate earnings. Heading into the second half of 2019, Q2 earnings season is getting underway. The expectation is for a slowdown in revenue growth rates compared to 2018, while investors will be looking for clues in company guidance. The recent truce between the U.S. and China arranged at the G-20 meeting and a hope for a Fed rate cut later this year have provided the latest push higher for stocks. With that said, our view is more bearish considering valuation concerns among key market-leading stocks and an expectation of weaker economic growth going forward, which should be a net negative for the market.

DIA Performance

DIA YTD Performance

(Source: Data by YCharts/Chart by author)

28 of the 30 holdings in DIA have positive returns this year. Microsoft and Visa (NYSE:V) are the best performers, up 36% and 34% respectively. 3M Co. (NYSE:MMM) and Walgreens Boots Alliance (NASDAQ:WBA) are the worst performers, each down over 10% over the past year. The stock returns off their respective 52-week low are even more impressive, as the average stock is up nearly 30%. Procter & Gamble (NYSE:PG), for example, is up 47% from its 52-week low and is the biggest winner over the past year.

DIA Total Return Performance Metrics

(Source: Data by YCharts/Chart by author)

DIA Valuation Metrics

DIA officially has a stated forward P/E ratio of 16.8x, according to the fund manager State Street Advisors. However, when using the data set and taking a weighted average based on the fund composition of published metrics, we find a forward P/E of 18.8x. The difference is significant enough and highlights the difficulty of gauging fund-level valuation assumptions. The difference of a couple outliers or adjustments to one-off items can have a significant impact, especially to a fund with only 30 holdings like DIA. State Street notes expected EPS growth over the next 3-5 years at 10.23%, which is a subjective forecast and a difficult number to estimate.

DIA Key Stats

(Source: State Street Advisors)

The table below presents valuation multiples for the underlying holdings sorted by enterprise value-to-sales (revenues). This is our favorite multiple, because it controls for differences in debt levels across companies compared to the price-to-sales ratio. EV-to-sales tells us the value of the company, including both the equity value and net market value of debt, relative to the amount of sales it generates. Sales/revenues are less susceptible to accounting rules or non-recurring impacts. The numbers are typically only comparable within industries, since it's understood that different types of business utilize various levels of leverage. Still, one of the trends we're observing is that valuation multiples for many of the companies in DIA are now at the higher end of their own historical trading range. This suggests the fund is expensive by some measures and potentially overvalued.

DIA Valuation Metrics

(Source: Data by YCharts/Chart by author)

The data shows that a large portion of the underlying stocks in DIA are at historically "expensive" valuations, even if the average figures are balanced lower by some underperformers. Boeing, for example, is down 21% from its 52-week high, taking a hit from the impact of the 737 Max plane crashes. The move lower helped return its valuation to more attractive levels. Given BA's weighting of 8.9% in DIA, the company's poor performance recently has dragged the index lower, but at the same time pulling the average valuation multiples for the fund down.

Not every company is trading at stretched multiples, but at least the 10 presented below, or one-third of DIA's holdings, have EV/revenue multiples that are at the highest level this decade. In some cases, these stocks with data going back 20-30 years show they have never previously traded at such multiples, or at least since the early 2000s at the height of the tech bubble. The straight price-to-sales multiple also shows similar trends for the group. Visa, with an EV/revenue ratio at 18.3x, is the highest in the group. The explanation is that many of these firms have become more profitable in recent years, with higher margins driving the stock price while revenue growth is slower.

DIA Holdings EV/Revenue Time Series

(Source: Data by YCharts/Chart by author)

In our view, companies including Procter & Gamble, McDonald's (NYSE:MCD), Johnson & Johnson (NYSE:JNJ), and Coca-Cola (NYSE:KO) are trading at a new paradigm of valuation despite uninspiring revenue growth. We argue that stocks in general trading at high multiples are higher-risk, as the potential fall following a poor earnings release or turn in the cyclical cycle will be exacerbated as the market looks to historical averages to ultimately price a bottom. The trends here add to our bearish view on the market.

DIA Dividends

DIA's Underlying Dividend Yields

(Source: Data by YCharts/Chart by author)

The chart above presents dividend yields by the underlying components of DIA. The ETF itself has a stated dividend yield of 2.1%, which is lower than a straight average of 2.5% among the underlying stocks. Chemical manufacturer and an only "Materials" sector component of the index, Dow Inc. (NYSE:DOW), has the largest dividend yield in the group at 5.8%.

Chart Data by YCharts

Forward-Looking Commentary

The market is pricing in a near-100% probability of a rate cut at the next Fed meeting on July 31. We see the broader implications as negative, given the rate cut would confirm either that the last rate hike in December 2018 was a mistake or that the underlying weakness in the economy is serious. Between now and the Fed meeting, a number of important economic indicators, including CPI, retail sales, and consumer confidence, could tilt the odds, adding to uncertainty.

The combination of diverging macro signals among uncertainty in the interest rate trajectory and emerging signs of weaker global growth warrants caution at current levels. DIA is effectively "the market", and its direction will be based as much on the underlying firms' growth outlook as with the general sentiment in financial markets. A sense that the Fed is making a mistake or losing control could induce a sell-off. The other important monitoring point is not only developments in the U.S.-China trade dispute, but also macro indicators out of China. Any indication that the Chinese economy is slowing down beyond expectations will be negative to global growth estimates, with implications for various asset classes. Expect the upcoming earnings season to include more pessimistic guidance by management teams, which could be followed by revisions lower to earnings estimates.

On the brighter side, a stronger-than-expected earnings season, coupled with renewed momentum in economic indicators, along with a potential favorable resolution to the trade dispute, could open the door for a leg higher in the market. It's a lot to ask for, but the bulls here can always hope. Take a look at DIA's fund prospectus for a full list of risk and disclosures.

Disclosure: I am/we are short PG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.