Image shows a picture of Lindsey Bell, Ally Invest’s chief investment strategist. The title reads “Old Dow, New Lessons.”

A century-old stock index is grabbing Wall Street’s attention, just as many of the hot stocks are seemingly falling out of favor.

The Dow Jones Industrial Average has stood unusually strong this year, especially in the recent selloff. While the tech-heavy Nasdaq 100 dropped as much as 11%, the Dow only slid about 3%, signaling the market’s most established stocks largely avoided the weakness.

This week, the Dow climbed back to record highs and crossed the 32,000 mark for the first time ever.

Graph titled The Dow’s Success in 2021 shows year-to-date returns for the Dow, S&P 500 and Nasdaq 100. While they generally follow the same track (mostly between –2% and 4%), the Nasdaq starts to drop in mid-February, while the Dow and S&P 500 rise in late February and early March, ending at 6.1% (Dow), 4.9% (S&P 500) and 1.3% (Nasdaq 100).

Investors have been quick to write off the Dow, especially when it’s been the underdog of the market indexes for years. But the Dow’s success these days may teach us some important lessons about the future of markets and the economy.

What is the Dow?

First, a quick refresher on the Dow.

The Dow was created in 1896 by Wall Street Journal co-founder Charles Dow. The index, which was made up of 12 industrial stocks, was one of the first benchmarks used to track the health of the entire economy. Back then, Charles Dow calculated the index values by hand, adding the share prices together and dividing the total by the number of stocks (a method called price weighting).

Today, the world looks completely different. Now, the Dow consists of 30 big U.S. companies with established track records (“blue chip stocks”). There are a few old-school stocks – Boeing, McDonald’s, Johnson & Johnson – mixed in with some (relatively) newer names – Salesforce, Microsoft and Visa, for example. But most Dow stocks have been around for decades.

Importantly, the performance of the Dow is still based on the price weighting of each stock in the index. Many other major indexes are calculated using their members’ market caps (such as the S&P 500). Because of this method, high-priced stocks tend to have the most influence on the Dow’s daily moves.

Currently, UnitedHealth and Goldman Sachs have the top weights in the Dow because their shares trade for over $300. Apple has the eighth-smallest weighting in the Dow (at about $120 per share, as of March 11) even though it has the largest weight in the S&P 500. As you can imagine, that has impacted the Dow’s performance over the past decade.

To put it into perspective, a $1 change in the price of any of the Dow stocks results in a 6.58 point move in the index.

The Dow’s Top Members (by Weight)

Rank Name Share Price Weight Sector Years in Dow Year-to-Date Performance
1 UnitedHealth $354.02 7.3% Health Care 8 0.7%
2 Goldman Sachs $335.90 6.9% Financials 7 30.2%
3 Home Depot $266.50 5.5% Consumer Discretionary 21 1.2%
4 Microsoft $234.50 4.8% Information Technology 21 6.9%
5 Boeing $233.40 4.8% Industrials 34 17.7%
6 Amgen $230.03 4.7% Health Care 1 1.3%
7 Visa $222.06 4.6% Information Technology 7 3.6%
8 Caterpillar $219.09 4.5% Industrials 30 21.4%
9 Salesforce $212.75 4.4% Information Technology 1 -3.0%
10 McDonald's $209.98 4.3% Consumer Discretionary 35 -0.8%

Source: Ally Invest, Dow Jones, S&P 500, Bloomberg

The Dow’s Evolution

In some ways, the Dow has been slow in keeping up with the times. That’s part of why most of Wall Street tends to use other indexes as market barometers, even though the Dow is often quoted in the media.

Another major difference between the Dow and other major indexes is its lack of big tech stocks. About 21% of the Dow’s weight is generated from the tech sector, and only one of the FAANG stocks is represented.

The absence of tech has weighed on the Dow’s returns, especially recently. The S&P 500 has posted better returns than the Dow in six of the last 10 years. Last year, the S&P 500 outperformed the Dow by nine percentage points, the widest margin since 1998.

The Lessons

This year, the Dow is thriving as the hot stocks are stumbling. About a third of the Dow’s stocks have made record highs since February 12, while popular Nasdaq stocks such as Tesla and Peloton are at least 20% from their own peaks.

Why the reversal of fortune? While some of it can be explained by the Dow’s price-weighting, most of it points to a bigger shift in the market. Investors have gravitated toward cyclical and value stocks that could do well as the economy recovers, and many of those stocks can be found in the Dow.

But that’s not the whole story. Here’s what else we’re learning:

There’s still opportunity out there. Many stocks may look expensive, but there are parts of that market that still look cheap compared to their earnings growth potential. Many of the Dow’s top performers this year have been financials and industrials – two “reopening” sectors that could continue to benefit from the end of the pandemic.

Less economic worry, more profit-taking. The Dow’s strength could show the recent drop has been more about profit-taking in popular sectors. Companies in the Dow tend to be more sensitive to the economy’s ups and downs, so we’d expect the Dow to fall further than it has if there was serious concern about the economic outlook.

The recovery is broadening out. Many big, global companies were left out of the market’s recovery last year. Stocks such as Intel and Coca-Cola still haven’t reclaimed their pre-COVID prices. Now, some of the unloved stocks are leading the market higher. This is a positive sign because it shows other areas of the market are starting to take part in the gains. A strong rally needs a solid foundation.

The Bottom Line

The Dow may not be the best measure of the stock market these days. But when stocks break rank from the rest of the market, we pay attention. Dow stocks could be getting their day in the sun as the COVID market recovery reaches cyclical and value stocks, and that’s a good sign for where the economy and markets are heading.

Recent market moves are also a good reminder to look beyond the hot stocks. Markets change over time because of several factors, including the economy, earnings, emotions and long-term societal trends. If you don’t want to play the guessing game, it may make sense to spread your money out across different sectors.

Callie Cox, Senior Investment Strategist, contributed to this article.


 
Speech bubble icon next to text "Expert Take"

Headshot of Lindsey BellLindsey Bell is Ally’s Chief Investment Strategist, responsible for shaping the company’s point of view on investing and the global markets. She is also President of Ally Invest Advisors, responsible for its robo-advisory offerings. Lindsey has a broad background in finance, with experience on the buy-side and sell-side, in research and in investment banking and has held roles at JPMorgan, Deutsche Bank, Jefferies, and CFRA Research.

Lindsey holds a passion for teaching individuals how to become successful long-term investors. She is a contributor at CNBC, and frequently shares her insights with various publications including the Wall Street Journal, Barron’s, MarketWatch, BusinessInsider, etc. She also serves on the board of Better Investing, a non-profit organization focused on investment education.

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The opinions expressed here are not meant to be used as investing advice. For more information, visit our website.