The Dow Jones Industrials (DJINDICES:^DJI) succeeded in posting modest gains on Tuesday, and although its five-point gain wasn't quite enough to send the average into record territory, it fared much better than the half-percent drop in the Nasdaq Composite (NASDAQINDEX:^IXIC) and the 1% decline in the small-cap Russell 2000 (RUSSELLINDICES:^RUT). Much of the reason the Dow held up so well compared with other market benchmarks has to do with comments that Federal Reserve Chairwoman Janet Yellen made in testimony before Congress today and some prepared Fed reports that accompanied her testimony.

Federal Reserve Building. Source: Dan Smith.

Positioning the Fed
The Federal Reserve is in a tough situation right now, as it tries to navigate a course to return monetary policy to more normal conditions while still giving the economy the support it needs to keep expanding. Rising inflationary pressures have encouraged more hawkish members of the Federal Open Market Committee to suggest a faster path toward not only ending quantitative easing but also raising short-term interest rates. Yet Yellen said that the economy still demands an accommodative monetary policy stance, reaffirming the generally less aggressive approach that remains the consensus of the broader Fed.

At the same time, the Federal Reserve is well aware that long periods of low interest rates can spawn artificial asset bubbles. If borrowers become used to the idea that they can count on refinancing debt at low rates for the long haul, then they'll take advantage of those conditions to borrow in order to invest in higher-return assets. That investor demand pushes asset prices higher, and when low rates finally end, the resulting flood of selling pressure can crush markets for those assets and leave less sophisticated investors holding the bag.


Fed Chair Janet Yellen. Source: Federal Reserve.

Perhaps because of those concerns, Yellen and the Fed took the extraordinary step of actually calling out portions of the stock market as having "stretched" valuations. Among them were shares of small-cap stocks, as well as companies in the biotechnology and social media industries. As a result of the Fed's attention, shares of those stocks fell more dramatically, and that led to the carnage on the Russell 2000 and the Nasdaq Composite today.

Is the Dow off the hook?
It might be tempting to say that the large-cap stocks among the Dow Jones Industrials are mostly immune from these impacts. After all, those stocks are large and liquid enough that short-term trading factors don't affect them as much.

Yet in many ways, even stocks among the Dow 30 have seen stretched valuations to some extent. Especially among high-dividend Dow stocks, earnings multiples have crept up even for companies in low-growth industries. High demand for those shares reflect some investors' fear of the broader market, but it also could be related to the simple strategy of borrowing money at low short-term rates and investing in stocks that pay greater amounts of income through dividends. Rising margin debt supports that hypothesis.

Therefore, you shouldn't conclude from today's market action that the Dow Jones Industrials will be able to avoid market downdrafts. Even if certain sectors of the market are overextended, the entire market has gone a long time without even a modest correction. Smart investors need to recognize the potential for a pullback and set their expectations accordingly.

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Dan Caplinger and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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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