Dow's Surge May Signal A Shift To Value Stocks

The dowdy Dow Jones industrial average has suddenly turned into the hottest game in town.

The Dow, of course, closed above 10,000 on March 29. That was a milestone, but it is not the real story. From Jan. 1 through Friday, the Dow, led by unsexy firms such as Caterpillar Inc. (CAT) and Alcoa Inc. (AA), has returned 14.3 percent, in both increased prices and dividends. By contrast, the Standard & Poor's 500-stock index, dominated by go-go companies, has returned only about half that, 7.3 percent.

The Dow rose in every session from Tuesday through Friday while the S&P fell in every session. Since April 6, the Dow has gained 5 percent while the S&P was dead even and the Nasdaq composite index, last year's champ among the major averages, fell 3 percent.

What's going on here? It may be too early to jump to conclusions, but the market, which has been powered for so long by mega-cap high-tech growth stocks, appears to be broadening. Slightly smaller companies with a value bent may be coming back.

If "rotation," as financial mavens call this phenomenon, is actually occurring, then it's about time. It's also a reminder to small investors that trends don't last forever. Groups that are out of favor come back; groups that are sizzling cool off. The lesson is to hold on to good companies, even when the market shuns them. Or, better yet, buy more. They'll be back.

An illustration of this point is that, over long periods, the returns of the Dow and the S&P are remarkably similar even though their component parts are so different. For the 10 years ended April 15, for example, the Dow returned an annual average of 18.35 percent, according to Bloomberg News; the S&P, 18.49 percent.

But lately, the divergence has been striking. In 1998, the Dow returned 18.1 percent while the S&P returned 28.6 percent. In 1997, the Dow returned 24.9 percent; the S&P, 33.4 percent.

While the Dow contains only 30 stocks, it is a more democratic index than both the S&P and the Nasdaq, which are dominated by techno-behemoths.

The S&P and the Nasdaq are both weighted by market capitalization, or the value that investors place on a company. The stocks that move the S&P are simply the largest stocks on all the exchanges. But of the top 15 S&P stocks, seven are not in the Dow at all; five are high-tech companies, including number one Microsoft Corp. (MSFT) and number three Intel Corp. (INTC), and two are drug firms. Four of the seven are the giants that move the Nasdaq: Microsoft, Intel, Cisco Systems Inc. (CSCO) and MCI WorldCom Inc. (WCOM).

The Dow, on the other hand, is more equally weighted. Technically, the companies with the highest stock prices have the most effect on the average's ups and downs, but because stocks are continually splitting their shares, the leadership changes over time. The leaders right now are International Business Machines Corp. (IBM), United Technologies Corp. (UTX) and J.P. Morgan & Co. (JPM).

More important, the folks at Dow Jones & Co. who choose the stocks for the average look for solid companies with long-term track records and dividend payouts. Despite its title, the Dow is no longer an "industrial" average; it has retailers such as Sears, Roebuck and Co. (S), consumer-goods firms such as Coca-Cola Co. (KO), and financial companies such as Morgan and American Express Co. (AXP). Its members all trade on the New York Stock Exchange rather than on the upstart Nasdaq.

Not all of the 30 Dow stocks are giants. Union Carbide Corp. (UK), for instance, has a market cap of just $7 billion, or one-fourteenth the size of the 30th-largest S&P stock.

Also, Dow stocks are more value-oriented than S&P stocks. In other words, they are more likely to be overlooked bargains, rather than highfliers with soaring earnings and stock prices and high P/E (price-to-earnings) ratios. In fact, the average P/E of the Dow stocks last week was 26 while the P/E of the S&P stocks was 34.

Another measure of a value stock is dividend yield; higher yields indicate a relatively lower price. The Dow currently has a dividend yield of 1.5 percent; the S&P, 1.2 percent. And many of the S&P big shots--including Microsoft, Cisco and Dell Computer Corp. (DELL)--don't pay dividends at all.

In fact, the Dow's high-dividend stocks have been doing especially well lately. Wayne Nelson of the Washington office of Merrill Lynch & Co. points out that on March 8 his firm launched its latest unit investment trust based on the Dogs of the Dow strategy (buy the 10 highest-yielding Dow stocks, sell in 12 months, repeat), and by April 15 it had gained an incredible 13 percent. Of the top four Dow performers over the past six weeks, three were dogs.

When you look more carefully at the Dow's success this year, you find that the big movers have been the companies in some of the dullest businesses, with the lowest P/Es. Through April 15, Alcoa, the aluminum maker, which started 1999 with a P/E of 15, has been up 44 percent; Caterpillar, the heavy-equipment manufacturer, which began with a P/E of 11, has risen 34 percent.

Other significant gainers: DuPont Co. (DD), the nation's largest chemical company, up 28 percent; Boeing Co. (BA), the world's largest aircraft maker (and one of my favorites at the start of the year), up 28 percent; Allied Signal Inc. (ALD) and United Technologies, two diversified manufacturers, up 27 percent and 30 percent, respectively; and International Paper Co. (IP), the world's largest forest-products firm, up 24 precent.

All of these companies, whatever their merits, had been left in the dust by galloping high-tech firms. Now they are surging. One reason could be that the broad strength of the economy is evident, even to financial analysts, so Wall Street does not have to concentrate only on the fastest growers. But a more important reason is probably that these stocks have been down so long that investors can't resist them.

DuPont, for example, is a fine company that has been increasing its earnings at a double-digit rate, on average, for the past 10 years, and yet it traded at $56 a share in March 1997 and $56 in March 1999. It closed Friday at $67.75.

Citigroup Inc. (C), the new financial supermarket formed last year by the merger of Citicorp and Travelers Group, fell 7 percent in 1998, but it's risen 43 percent in 1999 as investors bid up shares that started the year with a P/E below 20. Morgan is a similar story: Down 4 percent in 1998, it has rebounded by more than 25 percent.

Meanwhile, the Dow's two high-tech stocks have been dullards. IBM, the number-one stock on the index, with a 7.5 percent weighting, has fallen 4 percent in 1999; Hewlett-Packard Co. (HWP) has risen 4 percent, or less than one-third the gain of the average stock.

But it's foolish to say that tech stocks are out of favor. Great ones thrive. Microsoft is up 28 percent this year; Inc. (AMZN), the online retailer (and another of my favorites), has risen 56 percent; and AT&T Corp., which could be considered both a tech stock and a utility, has been the biggest Dow winner, with a 66 percent gain.

But AT&T is an interesting case. It is really a value stock, beginning the year with a P/E of 26--about one-fourth below the S&P average and far below its own spinoff, Lucent Technologies Inc. (LU), at a P/E of 93. AT&T has long been a top holding of one of the best-known value-oriented mutual funds, the Torray Fund.

Will the Dow trend continue? There is no way to tell, but investors should consider these wallflowers for their portfolios. The easiest way to buy all 30 stocks of the Dow, with their correct weightings, is through the Diamonds Trust Series I, which can be bought and sold just like an individual stock on the American exchange under the symbol DIA. Diamonds trade at about one-one-hundredth the value of the S&P. On Friday, they closed at $104.53 1/8. The management fee is only 0.18 percentage points a year, but you'll have to pay a broker to buy and sell.

Another intriguing alternative is the Strong Dow 30 Value Fund (1-800-368-1683), co-managed by Charles Carlson and Richard Moroney, editors of the Dow Theory Forecasts newsletter. Its expenses are capped at 1.4 percent a year. Carlson explained that half of the fund's assets are directly correlated to the Dow--they have the same weightings as the index. For the other half, he has discretion. He can load up on some Dow stocks and ignore others.

So far this year, his strategy is paying off. He is about 1 percentage point ahead of the Dow, after trailing it by 2 points last year. Carlson told me last week that he has overweighted Citigroup, Merck & Co. (MRK) and AT&T, but in the managed part of the fund, he owns no shares of Coke, McDonald's Corp. (MCD) or Procter & Gamble Co. (PG).

Carlson's aim is to emphasize value stocks even more than the Dow itself does. But these days, he can't ignore growth. "I'm value-oriented," he says, "but I am not inclined to stand in front of a freight train." That sounds like a sensible philosophy.

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About the Author


James K.
  • James K. Glassman is a visiting fellow at the American Enterprise Institute (AEI), where he works on Internet and communications policy in the new AEI Center for Internet, Communications, and Technology Policy.

    A scholar, diplomat, and journalist, Glassman rejoins AEI after having served as under secretary of state for public diplomacy and public affairs, during which time he led America’s public diplomacy outreach and inaugurated the use of new Internet technology in these efforts, an approach he christened “public diplomacy 2.0.” He was also chairman of the Broadcasting Board of Governors, the independent federal agency that oversees all US government nonmilitary international broadcasting. Most recently, Glassman was instrumental in the creation of the George W. Bush Institute, where he remains the founding executive director.

    Before his government service, Glassman was a senior fellow at AEI, where he specialized in economics and technology and founded The American, AEI’s magazine, which he led as editor-in-chief until his departure from AEI in 2007.

    In addition to his government service, Glassman was a former president of The Atlantic, publisher of The New Republic, executive vice president of US News & World Report, and editor-in-chief and co-owner of Roll Call. As a columnist for The Washington Post, Glassman wrote about political and economic issues. He was also the host of CNN’s “Capital Gang Sunday” and of PBS’s “TechnoPolitics.” In 2000, he cofounded TCS, a technology and policy website. His most recent book is “The Secret Code of the Superior Investor” (Crown Forum).

    Glassman has a B.A. in government from Harvard College where he was a managing editor of The Crimson.


  • Email: [email protected]

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