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Dow Cheap By Both Technical & Fundamental Analysis at Trader’s Narrative

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Today the venerable Dow Jones Industrial index is undergoing changes to its component stocks: Altria Group, formerly Philip Morris (MO) and Honeywell (HON) are being replaced with Chevron (CVX) and Bank of America (BAC).

Actively Passive
Which explains why I always chuckle when people get into debates about “passive” (aka index) funds vs. “active” funds. As today’s change should evidence, all funds, including indexes are active.

Somebody has to decide: a] what to put into an index b] rebalance it using some formula and c] make changes to the components, from time to time.

In an active fund, those calls are made by the manager who charges a hefty fee and in the case of an index fund like the Dow Jones the decision is made by the editors of The Wall Street Journal. Same difference.

The only real distinction is the portfolio turnover and the MER. While changes to the Dow happen every few years, an actively managed portfolio can have positions traded into and out up to several times a day.

Better Out Than In
Another interesting twist to this debate is that historically, stocks deleted from the Dow Jones end up outperforming the ones that replace them. That goes for not just the Dow but all major indices.

For example, Chevron was in the Dow before until it was deleted on November 1st, 1999 in a swap that involved 3 other boring stocks getting dumped for sexier stocks: Home Depot (HD), Intel (INTC), Microsoft (MSFT) and SBC Communications - now AT&T (T). The editors of the WSJ weren’t immune to the lure of the internet bubble.

The four new stocks went on to produce an average loss of 40% while the deleted and unloved stodgy ones produced an average gain of 27%. So the Dow would have been much better off had there been no changes at all!

The most (in)famous change to the Dow is the elimination of IBM from the index in 1939. While it was eventually added again, according to Norman Fosback, the Dow would now be twice what it is today had there been no change.

Still like indexing? still think it is passive?

Technical Analysis
Rather than a typical technical analysis of the Dow using its own chart, I thought I’d share something a bit more advanced and perhaps more insightful.

The chart below is a ratio of two breadth indicators: the percentage of Dow components above their 50 day moving average, divided by the percentage of Dow components above their 200 day moving average. If it sounds familiar, you’ve probably read this: “Timing the Market with % Above MA Ratios

percent dow stock above 50 200 MA long term

Whenever the ratio spikes, the Dow is extremely oversold. The current ratio has spiked because the denominator is 13.33% - the lowest it has been in five years.

Anything in the 2.0+ range is beyond extreme. We’ve only exceeded this level in recent times when the market was making the 2002-2003 bear market bottom.

Fundamental Analysis
According to Morningstar’s fundamental analysis, the Dow is undervalued by 17%. They arrived at this valuation by doing an analysis of each component. They also expect the index to rise 50% in the next 3 years.

According to Jeffrey Ptak, “The Dow hasn’t looked this cheap to us since September 2002 when the index stood at 7,592″. Sound familiar? ;-)

The research note was released before today’s changes to the Dow but Morningstar added a note saying that Chevron and Bank of America will actually make the Dow even more undervalued, reducing both trailing and projected price earnings ratio and increasing the dividend yield.

I’m not big on fundamental analysis but when it dovetails so neatly with technical analysis, I can’t help but take notice. Oh and for another take on the general market fundamentals, take a look at the IBES model.

Remember to add your own thinking and due diligence.

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