Until This Happens, You Can't Trust the Dow's Record Highs

Stock investors need to look beyond the Dow to judge the health of the stock market.

May 13, 2014 at 11:00AM
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The Dow Jones Industrials' (DJINDICES:^DJI) 112-point rise on Monday was the third time the index has set a record in 2014, but it was the first time that it reached a new all-time high with a convincingly strong move. Yet before convincing yourself that the Dow's bull run has a lot further to go, wait to see if the lagging portions of the stock market can catch up.

What's hot and what's not
The Dow and the S&P 500 (SNPINDEX:^GSPC) both set fresh record highs yesterday, showing the strength of the largest, best-known stocks in the market. From a longer-term perspective, the Dow Jones Industrials have posted impressive returns over the past five years, with blue-chip stocks rebounding convincingly from the depths of the financial crisis.

Yet as well as the Dow Jones Industrials have performed, the Nasdaq Composite (NASDAQINDEX:^IXIC) and the Russell 2000 (RUSSELLINDICES:^RUT) have produced even more impressive returns since 2009. Take a look at how far they climbed in the five years following the March 2009 market lows:

^DJI Chart

Dow data by YCharts.

There are several reasons why the Nasdaq Composite and Russell 2000 have outperformed the Dow Jones Industrials. As far as the Dow fell during the financial crisis, the smaller stocks that make up the Nasdaq and the Russell fell even more dramatically. Many companies' entire survival was put into question. When they recovered, these companies had a lot more ground to regain than their larger counterparts.

Moreover, as the bull market aged, investors became more interested in growth stocks. The Dow Jones Industrials have precious little growth potential compared to the hot up-and-coming companies that make up the Russell 2000 and parts of the Nasdaq Composite, and so investors gravitated toward those stocks.

Lately, though, investors have reversed course and gotten nervous about the sustainability of the bull market. They have therefore changed their investing strategy, and that has hurt small caps and the Nasdaq to the benefit of the Dow:

^DJI Chart

Dow data by YCharts.

What you can see here is that the Nasdaq and the Russell 2000 aren't just trailing behind the Dow -- they're trailing the Dow badly, having underperformed by no less than 5 percentage points in just the past couple months.

What's next?
The big question is whether the Dow Jones Industrials will keep rising on their own. Many market participants who use mechanical or technical strategies look closely when one part of the market does worse than the other, and they're presently unconvinced that the Dow will keep climbing without support from the broader market -- including small-cap stocks.

As a result, until you see the Nasdaq Composite hit a new 14-year high, and see the Russell 2000 match its all-time record level from March, you should take the record run in the Dow Jones Industrials with a grain of salt. Otherwise you could find that the Dow is giving you a headfake that could lead to a more severe market correction in the near future.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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