The Dow's New High Signals Change

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The Dow looks closed at a new high for the year yesterday, led by gains in Caterpillar (NYSE: CAT), American Express (NYSE: AXP), and IBM (NYSE: IBM). Normally, I would advise investors not pay much attention to this sort of "event." However, I think this high could be symbolic of a shift in the market away from lower-quality/higher-risk names to higher-quality stocks. If so, investors need to take note and, if necessary, reposition their portfolios.

A sign of change?
I've been railing on about "quality" stocks for several months, based on the fact that they are underpriced relative to the broader market. The Dow, a large capitalization, blue-chip index has trailed the broader S&P 500 and the small-cap Russell 2000 index so far this year. Since the beginning of October, however, it is outperforming both (see table below). Is the train beginning to pull out of the station?

	Year-to-Date Return	Q4 Return
Dow Jones Industrial Average	16.5%	5.3%
S&P 500	21%	3.4%
Russell 2000*	20.1%	(1.9%)

*Total returns.
At Nov. 9, 2009.
Source: Dow Jones Indexes, Standard & Poor's, and Russell Investments.

Do the new highs signal a durable shift toward the higher quality segment of the market or is it simply a blip in the chart? That's unknowable, and the S&P 500 was also up smartly yesterday. Either way, that the S&P 500 is currently overvalued is undeniable; consequently, investors should be underweight U.S. equities except inasmuch as they own well chosen stocks with attractive valuations.

There is still time to act
Fortunately, it's not too late for investors to "upgrade" their holdings. On the basis of price-to-forward earnings, for example, almost half the stocks in the Dow trade at a lower multiple than the S&P 500, including Merck (NYSE: MRK), Hewlett-Packard (NYSE: HPQ), Johnson & Johnson (NYSE: JNJ), and Wal-Mart (NYSE: WMT).

As we emerge from the recession, this is exactly the time to buy these stocks.