Investors have to love 2021 so far. The market has dished out gains to nearly every sector, with the Dow Jones Industrial Average (^DJI -0.12%) up a solid 16.5% year to date. All told, the index now sits more than 80% above its March 2020 lows, marking one of the biggest 21-month advances ever seen.
And yet, it would be naive to assume all is right with this big rally. The domestic and global economies have pushed past the initial impact of the pandemic, but the scope of the gains seems and feels bigger than the true depth of the recovery. Inflation remains dangerously high, as do stock valuations.
Is it too late to ride the Dow bus higher? Image source: Getty Images.
On the flip side, not everything can be boiled down to raw numbers. Sometimes investors have to assume some level of faith that future earnings will justify current prices. That's certainly the case now, although that stance is tainted by a major footnote.
Frothy valuation
No, it's not too late to buy. Do know, however, that stocks in general and the Dow Jones Industrial Average, in particular, may not be able to climb as easily in the near future as they have in the recent past.
Much of that headwind can be chalked up to the collective price-to-earnings (P/E) ratio of the Dow's 30 constituents. Data from Dow Jones and market research firm Birinyi Associates indicate the Dow is now priced at 22.2 times its trailing-12-month earnings, versus a long-term average in the ballpark of a little less than 16. The forward-looking P/E ratio of 17.7 is more in tune with the long-term norm, especially in light of the remarkably low interest rates we're still seeing (cheaper money tends buoy valuations). Even so, the index's present price is well into the upper portion of its sustainable range even factoring in the pace of the recovery from the pandemic-prompted lull.
Perhaps worse, that rebound is indeed starting to slow. Standard & Poor's says this year's earnings for large caps will be 65% better than last year's COVID-19-crimped bottom lines. Next year's profit growth, however, is projected to be a considerably less impressive 9%. It's not disastrous, but it's also not the sort of exciting growth that supports the Dow's current and near-term earnings multiples.
The point is, investors are on a collision course with a harsh reality. The collision is apt to happen sooner rather than later. That's why any investors who have remained on the sidelines up until this point may as well stay there for a while longer.
The good news is, such a collision is more likely to result in a normal market correction, and not kick-start a full-blown bear market. (Fun fact: The Dow has only suffered one corrective move of more than 10% since the March 2020 plunge, and that was in September of last year. Given the huge gains logged before and after that lull, it's arguable we're overdue for a dip of this size.)
Not all indexes are the same, and it matters
With all of that being said, there's perhaps a more important yet more nuanced idea to consider here. That is, any short-term weakness from the Dow isn't just a buying opportunity within a bull market that's still well supported by decent economic growth. Any marketwide correction may also finally turn the tide in favor of blue-chip value stocks at the expense of growth stocks that have been leading the charge for a while now.
The graphic below puts things in perspective. While growth and value stocks performed similarly coming out of the subprime mortgage crises and subsequent recession in 2008-09, growth began to noticeably outperform value beginning in 2015. The performance disparity really started to widen in a big way early this year, when growth stocks emerged as the only apparent way to capitalize on the post-COVID-19 rebound.
^IVX data by YCharts.
But nothing lasts forever. The coming year could unwind many of the performance disparities we've seen of late. As Morgan Stanley's chief investment officer of its Wealth Management arm, Lisa Shalett, recently said, the "next market rotation could see value stocks on top." She goes on to explain "investors' U.S. market detour into growth and defensive stocks" is on the verge of winding down as inflation firms up at the same time the ever-improving jobs market will soon create a swell of demand for services as strong as the one it's already created for goods. And Shalett is hardly alone in her view.
This has implications for the Dow and other major market indexes.
While they're all meant to be broad market barometers, the Dow, the Nasdaq Composite (^IXIC -1.15%), and the S&P 500 (^GSPC -0.58%) aren't all cut from the exact same cloth. The Nasdaq Composite is steeped in the growth stocks that have led the market for a few years now. The S&P 500 is a balanced mix of value and growth. The Dow, however, leans more toward being a value-oriented kind of index, consisting heavily of old-guard, slower-growth service names such as Procter & Gamble (PG 0.65%), Coca-Cola (KO 0.78%), and Verizon (VZ 0.03%). If we are indeed going to see value stocks fall into favor at the expense of growth names, it's a shift that makes any impending dip from the Dow an even better buying opportunity.
Keep it in perspective
Of course, this sort of minutiae isn't always easy to capitalize on, and doing so isn't always of any clear benefit. Trying to perfectly time your entries and exits often results in poorer -- not better -- overall returns, and the value/growth tug-of-war is similarly difficult to take advantage of. True long-term investors will still be perfectly fine if they choose to ignore both nuances and simply keep holding good quality stocks.
If you're willing and able to do something constructive with the impending changes to the overall market's current situation, though, it just might make a bit of difference a year from now.
