History suggests time is right to buy Dow stocks
Are you too late to the rally?
One of the fastest bull markets in history pushed the Dow Jones industrial average to a close near 12,000 last week, the highest point for the index of 30 blue chip stocks in two and a half years. The broader Standard and Poor's 500 index, the benchmark for most mutual funds, flirted with similar highs. An investor who bought an S&P 500 index fund at its March 2009 low has doubled his money since then, assuming dividends were reinvested.
But lost in the attention focused on Dow 12,000 is the fact that it has lagged every other U.S. market index over the past 12 months. Large companies have only recently started to take the lead. That suggests that the bull market could push ahead despite the Dow's 1.4 percent drop on Friday when concerns about political turmoil in Egypt and a couple of disappointing earnings reports gave investors reason to sell.
Markets tend to move in cycles. Riskier smaller companies often fall hardest during a recession and perform the best coming out of one. Larger companies, which often hold more of their value during downturns, tend to perform better after a recovery turns into an economic expansion. After the tech bubble popped, for instance, small companies performed better than the Dow index every year from 2003 to 2006. Dow stocks performed better from 2006 to the start of the financial crisis in 2008.
That cycle is under way again. The Russell 2000, which tracks the performance of smaller companies, returned 27 percent after dividends each of the last two years. The Dow gained 22.6 percent after dividends in 2009 and 14 percent in 2010. So far this year, however, the Dow has gained 2.4 percent, while the Russell index has dropped 1.1 percent.
"We're getting closer to the cross-over point in the bull market," says Doug Godine, managing director at Signal Hill, an investment bank.
Dow stocks range from Caterpillar to Coca Cola and Merck to Microsoft. The index is meant to mirror the overall economy, which is improving. The Commerce Department said Friday that the gross domestic product, the broadest measure of the economy, grew at an annual rate of 3.2 percent from October to December. Economists expect consumer spending to double in 2011 from last year's rate. And businesses are starting to spend more money on computers, energy and basic products.
Dow components International Business Machines and Hewlett-Packard have jumped more than 8 percent since the start of the year. Another Dow member, General Electric, closed above $20 a share Monday, the first time since October 2008. The company said the previous Friday that fourth-quarter profit jumped 52 percent thanks to big gains from its GE Capital and energy infrastructure divisions.
The other reason Dow stocks are doing well lately: They're cheap by recent historical standards. The index's trailing price to earnings ratio, a measure that shows investors how much they are paying for a dollar in earnings, is 14.7, well below the 18.1 it has averaged since 2003. The price to earnings ratio for the S&P 500 index of large companies, meanwhile, is 17.3.
"Big stocks are still playing catch-up," says Bob Doll, chief market strategist at BlackRock, a firm that manages $3.45 trillion in assets. "As they go higher, investors are going to say 'Stocks are going up, so I better buy some more of them.'"