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Two Reasons Explain Why the Dow Lags the S&P 500 by Double Digits: NVIDIA and Meta

June 24, 2024
minute read

At the peak of the internet bubble in early 2000, the S&P 500 significantly outperformed the Dow Jones Industrial Average (DJIA), a scenario that mirrors the current market situation. This observation challenges the notion that the Dow's recent underperformance indicates a fundamental flaw, suggesting instead that the S&P 500 might be overvalued.

In the past six months, the Dow has trailed the S&P 500 by about 12 percentage points. Historically, the average six-month performance spread between these indices over the last decade is a mere 0.9 percentage points. The most significant disparity occurred on March 8, 2000, when the S&P 500 was 13.7 percentage points ahead of the Dow. This gap was followed by the Nasdaq Composite reaching its internet bubble peak two days later, leading to a significant market downturn.

This extreme case, however, is not the norm. Analyzing the correlation between the S&P 500-Dow six-month performance spread and subsequent market performance reveals no significant relationship. This indicates that the current spread does not provide reliable insight into the overall market's future performance.

However, the spread can offer clues about the future relative performance of value and growth stocks. The S&P 500 leans more towards growth stocks compared to the Dow, and historically, market leadership tends to oscillate between growth and value stocks. A substantial lead by the S&P 500 often precedes a shift in favor of value stocks.

The valuation ratios of the S&P 500's ten largest stocks highlight its growth orientation. Most of these stocks have high price-to-earnings, price-to-book, and price-to-sales ratios, alongside low dividend yields. Only four of these top ten stocks are included in the Dow, contributing to the large performance gap between the indices, especially given the significant contribution of the "Magnificent Seven" group to the market's performance this year.

The rotation between growth and value stocks was evident after the internet bubble burst in 2000. By April 2001, a year after the bubble's peak, the Dow outperformed the S&P 500 by nearly 16 percentage points over the trailing six months, marking a dramatic shift of about 30 percentage points in relative performance.

This cyclical market leadership between the Dow and the S&P 500 suggests that the Dow may eventually surpass the S&P 500 as significantly as it currently lags behind.

Despite its shortcomings, the Dow remains a widely recognized market benchmark. The main criticism is its price-weighting methodology, which assigns weights to component stocks based on their price rather than market capitalization. For instance, UnitedHealth Group, the highest-priced Dow stock, has significantly more weight than Intel, the lowest-priced stock. This method can lead to irrational weightings, such as when a stock split halves a company's weight in the index without any fundamental change in its value.

The Dow's price-weighting approach, chosen for simplicity in the late 1890s, contrasts with the S&P 500's capitalization-weighted methodology. Despite these differences, the long-term total returns of the Dow and the S&P 500 are surprisingly similar. Over the past 25 years, the SPDR Dow Jones Industrial Average ETF (DIA), which tracks the Dow, has achieved an annualized return of 7.6%, closely matching the 7.7% annualized return of the SPDR S&P 500 ETF (SPY).

In conclusion, while the Dow's underperformance relative to the S&P 500 might raise concerns, historical data suggests that such spreads are not reliable indicators of future market performance. Instead, they highlight the oscillating nature of market leadership between growth and value stocks, suggesting potential shifts in the coming months and years. Despite its methodological flaws, the Dow remains a valuable benchmark with long-term returns comparable to the S&P 500.

Bryan Curtis
Eric Ng
John Liu
Editorial Board
Bryan Curtis
Adan Harris
Managing Editor
Cathy Hills
Associate Editor

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