Digging Deeper into the Dow …

Tony is swamped with work this week, so he asked me to take his spot in Money and Markets.

My name is Mike Burnick, and I’m an investment research analyst over at Weiss Capital Management. Lately, I’ve been doing a lot of historical research into the Dow Jones Industrial Average, and I’ve found out some really interesting things.

Tony will be back next week to give you his latest thoughts on the markets. In the meantime, let me tell you about my findings …

The Dow Has Come A Long Way, But Alone

The financial media is in an absolute tizzy about the Dow finally making a new all-time high earlier this month.

However, it took the index six years to reach its previous high-water mark of 11,722 set on January 14, 2000. If you ask me, that’s a long time to wait just to break even!

Moreover, I’m not convinced that this new high is a reason to start popping champagne corks. Here’s why …

Since it bottomed out in October 2002, the Dow has already gained more than 60%. Plus, the upswing has continued for more than four years. That’s the fourth-longest bull-market run since 1900, according to Ned Davis Research. ¹

Since 1900, the Dow’s typical bull-market gain has been somewhat larger â€” 85%, on average. But if history is our guide, that means the index is already more than three-quarters of the way to the top of its current cycle.

History also demonstrates that new record highs in the Dow have not always led to spectacular new bull markets for the majority of stocks.

For example, in November 1972, the Dow jumped above the 995.15 mark for the first time in more than six years. Back then, Wall Street pundits also saw blue skies ahead.

And yet the index managed to rally just 5.7% higher from there. Then, another grinding decline began. In the chart, you can see that by October 1974, the Dow had again declined 45% from its record high just two years earlier.

It took another 10 years for the Dow to again hit a new peak.

While it’s hard to say whether history will repeat itself this time around, it’s worth noting that other indexes are not recording highs of their own:

The broader S&P 500 Index needs a gain of nearly 15% to reach its previous high.
The NASDAQ Composite would have to more than double to eclipse its last peak set in 2000.
Even the small-cap Russell 2000, one of the strongest-performing stock indices during the current bull market, is still about 8% below its record high set in May.

What this tells us is that the stock market’s rally since June has been predominately confined to a handful of large-cap stocks, such as the 30 companies that make up the Dow. By the way, even among these elite 30, many components have failed to reach new all-time highs during the index’s impressive run.

The bottom line: I don’t think the overall market is out of the woods just yet. That means it’s more important than ever to be selective when choosing your individual stock and sector investments.

Here Are Some Sectors To Look At Right Now

Because different styles of investing are best suited for different phases of the broader-business cycle, you need to know where we’re at right now in the cycle.

I believe the U.S. economy appears to be transitioning from a robust growth phase to a more mature period of slower growth. Just four of the signs:

The most recent reading of Gross Domestic Product (GDP) â€“ the broadest measure of our economy’s growth â€“ slowed from 5.6% in the first quarter to just 2.9% in the three months ended June.
Residential investment plunged approximately 10% in the second quarter. That’s a reflection of the rapidly deflating housing market.
The Department of Commerce reported that consumer spending rose only 2.6% last quarter â€” just over half the rate in the first quarter.
Business investment decelerated to 4.7%, still a healthy clip, but down sharply from a rate of 13.7% in the first quarter of the year. ²

What investments tend to outperform during this kind of environment? Large-cap stocks and defensive sectors of the market such as:

Consumer Staples: The companies that make the items that people use in good times or bad, including foods, beverages, household products, and tobacco.

Health Care: People also take their medications and go to see the doctor no matter what the economy does. For that reason, health care companies can weather slower economic growth better than many other firms.

Select Financial Stocks: I think certain companies in the financial sector will lead the market going forward. Take a look at the graph.

The defensive companies I’ve just described include names like Johnson & Johnson, Coca-Cola, and Wal-Mart. These are mega-cap, multi-national companies that have the proven ability for steady earnings growth and attractive dividend payouts. ³

Also, at this point, there’s another factor in favor of these blue chip stocks â€” attractive valuations.

While the S&P 500 Index has been languishing at its 2000 price peak, companies in the index have been increasing their per-share earnings (P/E) at a record pace. In fact, in the second quarter of this year, they notched their 17th consecutive quarter of double-digit year-over-year profit growth.

The result has been lower price-to-earnings ratios for these stocks. As you can see from the chart, the index now trades at just over 17.5 times trailing earnings â€” and just 15 times estimates of 2006 profits.

That’s well below the average P/E of 25.5 since 1994 â€” and the cheapest P/E ratio for the blue-chip index in more than ten years!

In other words, even though the S&P 500 Index has moved well above its bear-market low, it still has a long way to go on the upside to reach its average historical valuation over the past 12 years.

The S&P 500 includes stocks in all sectors. However, many of the defensive stocks I just told you about are trading at the cheapest valuations, on a relative basis.

For example, the 25 largest companies are priced at less than 14 times 2006 profits! And if you single out the 10 largest companies (in terms of market value), they not only trade at a discount to the overall S&P 500 â€” but have above-average yields, much higher returns on equity, and strong balance sheets. ⁴

In my view, the best potential for upside in the stock market might presently reside among the largest stocks. Large, established, blue-chip companies â€” those with stable, reliable profit and dividend-growth histories â€” may offer, perhaps, the best total-return potential as we move forward through the next phase of the economic cycle.

If you’re interested in going it alone, take a good hard look at these investments.

Or, maybe you’d rather let someone else do the heavy-lifting. If so, consider looking into Weiss Capital Management’s Weiss Select Equity Portfolio.

I think this core investment strategy is well positioned to take advantage of the trends I just told you about. Its goal is simple: To beat the S&P 500 on a total-return basis over a full market cycle.

To read more about the guiding investment philosophy behind our Weiss Select Equity Portfolio, please click here. You’ll receive our just-published report, “Value Investing: An Investment Strategy for Long-Term Success” as well as a complete information kit on the Weiss Select Equity Portfolio.

For more information, you can talk to a Weiss Capital Management Financial Adviser by calling 800-814-3045 (be sure to mention promo code MAM1017).

Sincerely,

Mike

Important Disclaimer:
Michael Burnick is an investment analyst at Weiss Capital Management. The opinions contained herein are those of Weiss Capital Management’s investment committee and are subject to change without notice.

¹ Wall Street Journal, October 4, 2006, Page A1
² Briefing.com August 30, 2006.
³ Weiss Capital Management may maintain positions in these stocks for some clients, in certain managed investment programs. This should not be interpreted as a specific recommendation to purchase these securities.
⁴ Legg Mason Capital Management, Fund Commentary, June 2006, David Nelson, CFA

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a, Arial, Helvetica, sans-serif” size=2>If you’re interested in going it alone, take a good hard look at these investments.

Or, maybe you’d rather let someone else do the heavy-lifting. If so, consider looking into Weiss Capital Management’s Weiss Select Equity Portfolio.

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For more information, you can talk to a Weiss Capital Management Financial Adviser by calling 800-814-3045 (be sure to mention promo code MAM1017).

Sincerely,

Mike

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