The Dow's New High Signals Change

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.

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Fool contributor Alex Dumortier, CFA, has no beneficial interest in any of the other companies mentioned in this article. American Express and Wal-Mart Stores are Motley Fool Inside Value recommendations. Johnson & Johnson is a Motley Fool Income Investor pick. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.


Read/Post Comments (2) | Recommend This Article (13)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 10, 2009, at 10:44 PM, mrspeabody wrote:

    i need some clarity, The MF reccomends regularly investing in an s&p 500 index fund as a basic first step in investing. with the s&p being overvalued as the above article states should a basic investor like me stop investing in an s&p 500 index fund?

  • Report this Comment On November 11, 2009, at 8:49 AM, TMFAleph1 wrote:

    @mrspeabody,

    Dollar-cost averaging into an index fund over very long periods will probably yield acceptable long-term returns. That is a robust, minimalist strategy.

    Investors who are willing to take a more active approach may be interested in knowing when the index is overvalued, as this will enable them to adjust their portfolio by reducing their exposure to the index. This knowledge is also invaluable for investors who have followed a pure dollar-cost averaging strategy and who are reaching the end of their saving/ accumulation years.

    I hope this is helpful.

    Best,

    Alex D

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