Dogs of the Dow in 2017: All Bark and No Bite

The Dow Jones Industrials (^DJI 0.44%) has produced strong returns so far in 2017, rising 8% and setting new record-high closes 20 times since the beginning of the year. Yet for those who had hoped to outperform the Dow by using a popular strategy that focuses on high-dividend Dow components, this year hasn't been the best. The Dogs of the Dow are underperforming the broader market, and they've just barely managed to gain any ground at all as the year approaches the halfway point.

Source: Dogs of the Dow website.

What are the Dogs of the Dow?

For those who aren't familiar with the Dogs of the Dow strategy, it's a simple way to try to improve on the performance of the overall Dow. To use the strategy, first figure out which 10 Dow stocks had the highest dividend yields at the beginning of 2017. Then, you invest equal amounts of money in each of the 10 stocks. Hold onto the stocks throughout the year, and at the beginning of 2018, you'll take a new look to see which 10 Dow components have the highest yields at that point. You can make replacements at that time, and then carry the strategy forward another year.

The Dogs of the Dow strategy has been quite successful recently. In six of the past seven years, the strategy has outperformed the returns of the Dow Jones Industrials, and it has generated greater amounts of income in the process. That makes the Dogs especially attractive to dividend investors.

Image source: Getty Images.

Why are the Dogs falling back this year?

However, as the table above shows, the Dogs of the Dow are well behind the overall Dow's performance. In general, there are four major reasons for the underperformance:

• Both of the Dow's energy stocks are among the Dogs this year, and with oil sagging again, both stocks are down almost 10% so far this year.
• The telecom sector is struggling from price competition, sending Verizon (VZ 1.61%) to double-digit percentage declines. For Verizon to recover, it will have to find a way to compete more effectively without losing so much of its profit margin that any victory becomes Pyrrhic.
• Many of the Dogs are doing worse than their non-Dog counterparts in the same industries. For instance, IBM (IBM -1.47%) is down 7% on the year, compared to positive returns of as much as 25% for tech peers elsewhere. While other tech companies have been able to take greater advantage of mobile connectivity, IBM is having to fight against equally large rivals for shares of the fast-growing cloud computing and data analytics business.
• The Dogs don't have their fair share of strong performers. Dog stock Boeing (BA -0.48%) is leading the entire Dow with gains of more than 25%, thanks largely to the success of the commercial aerospace industry in recent years. Improving prospects in military and defense should also bolster Boeing in the near future. But there's only one other stock with double-digit gains among the 10 Dogs of the Dow. That compares to 11 of the 20 non-Dog Dow stocks with gains of 10% or more so far in 2017.

Can the Dogs of the Dow recover?

It's too early to count the Dogs of the Dow out entirely. This year certainly isn't the first time that the Dogs have gotten off to a slow start, only to bounce back later in the year. In particular, because the Dogs of the Dow strategy combines elements of income and value investing philosophies, they will sometimes do better during times of greater market turbulence. Choppy markets often happen later in the year, especially in the historically challenging months of September and October, and that could give the Dogs an opportunity to catch up to and surpass the overall Dow.

The big question for the Dogs is whether initiatives that investors have anticipated all year will come to pass before the end of 2017. For instance, a boom in construction and infrastructure spending at the federal government level could drive heightened sales and profits at heavy equipment manufacturer and Dow Dog Caterpillar, and its stock has already risen in anticipation of favorable trends. If those programs get put in place, then the corresponding rise could help push the Dogs forward overall.

Conversely, pharma stocks have suffered from concerns over plans to control drug costs. With the two pure-play Dow pharma stocks both among the Dogs, any news that favors drug companies would disproportionately help the strategy's relative performance to the overall Dow.

The Dogs of the Dow aren't living up to investors' expectations, but the strategy still has some long-term advantages in terms of simplicity, volatility, and risk-adjusted return. Moreover, with more than six months left in 2017, the Dogs of the Dow have every opportunity to make up for lost time and emerge victorious this year.