DIA: The Dow Likely Beats The S&P 500 Over The Next Several Years (2024)

It's better to be broadly right than precisely wrong." - Warren Buffett

You wouldn't think the SPDR Dow Jones Industrial Average ETF Trust (NYSEARCA:DIA) would be the way to invest these days, would you? While it's still cited in market news about as often as the more comprehensive, statistically sophisticated, and precisely constructed S&P 500, it is seen by many as the last hairy mammoth left over from the Pleistocene Epoch. In fact, it is the last comprehensive large cap index put together by active decision makers, and thus is shaped in a way that is both old-fashioned and oddly up to date. It thus presents an interesting alternative for large cap "blue chip" investors. It has done surprisingly well in this role.

The Dow Averages are the oldest market-tracking indexes, going all the way back to 1884 when the Railroad (now Transportation) Average was invented by Dow Jones founder Charles Dow. The Transports, as they were often called, contained 9 railroads, one steamship line, and Western Union. Bear in mind that railroads were the great growth stocks of their day, so think of them as the Magnificent 9. In 1896, the same Charles Dow founded the Dow Jones Industrial Average, which started as an average of 12 stocks. Except for General Electric (GE), the 12 included commodity processing companies involving sugar, cotton, gas, lead, and rubber.

By 1916, the composition of the average, then made up of 20 stocks, had begun to tilt toward heavy industry such as iron, steel, and autos. The Dow Industrials have persisted in the effort to keep up with the important things going on in the economy. In recent years, growth and innovation have moved in the direction of high-tech companies with much focus on the Magnificent 7 tech companies, and the Dow Industrials now includes more tech than you probably think. In fact, I would argue that they own tech in just about the right amount.

The Dow Is Put Together Without Statistical Rigor, But It Somehow Works

The Dow Industrials and the other Dow Averages are "price weighted" indexes and have been since the beginning. As set up by Charles Dow, the simple approach was to add up the closing prices of each stock included in the index and then divide by 12. A smart 3D grader could do it. In statistical terms, it's a rather primitive and sloppy approach, but it worked well enough to track market trends and continues to do so. Over the long run, the Dow Industrials and S&P 500 are highly correlated despite a huge difference in methodology.

The first closing number for the Dow Industrials was 40.94, which suggests why the "price weighted" approach worked as well as it did. There were very few stock splits and no stock dividends in those days, so that the 40.94 was actually so close to the price of most stocks that it was unnecessary to take an action reducing the divisor. Thus, the number was roughly, though not precisely, the "average." One important thing the original Dow Averages did was to separate industrials from railroads. This led to the original premise of technical analysis, which was first put into writing in editorials written by that same Charles Dow, who was cofounder of Dow Jones and creator of the Dow Averages. The core premise: If a stock or the market as a whole is making important new highs, it is in a long-term bull market and the opposite is true of a bear market. It doesn't get much simpler than that. But there's more.

To be a true reversal of trend, the Industrials, and Railroads have to be in agreement. An all-time high in either has to be "confirmed" by a new high in the other within a reasonable period of time. Paraphrasing Investopedia, the assumption is that if business conditions are healthy, a rise in the DJIA might suggest that railroads would be profiting from moving the freight this business activity required. Thus, the Railroad (later Transportation) Average would also be rising. Technical analysts continue to use this principle today, with occasional tweaks which add other sectors to the Transportation Average.

Over 138 years, there have been a number of adjustments to the Dow Averages, while the basic premise of a "price-weighted" index has been retained. As stock splits took place among the now 30 stocks (since 1928), the divisor has been adjusted so that the market opens on the day following the split at the closing price of the previous day. For those interested in such things, the reason the Dow is so much higher than most of its individual stocks is that the number you divide by is now roughly .15, and dividing by any number smaller than 1 means that you effectively multiply by dividing.

Over the longer term, the Dow undertakes to replace companies which no longer fit with companies which better represent the ever-evolving economy. The selection process for companies added and companies kicked out is in the hands of a committee made up of two journalists from The Wall Street Journal and three from S&P Global. There's a vagueness in their few instructions which so far has worked very well in choosing 30 companies to represent the entire economy. The unspoken instructions are that a stock is typically added only if the company has an excellent reputation, demonstrates sustained growth, and is of interest to a large number of investors. That's the approximate definition behind the term "blue chip." The more specific requirements are that Dow stocks must be headquartered in the U.S., get the plurality of their revenues in the U.S., and help the index maintain the desired exposure to sectors.

While much less detailed and specific than the rules for most other indexes, these guidelines have performed well, bringing to mind the aphorism Warren Buffett borrowed from John Maynard Keynes that it is better to be broadly right than precisely wrong. Below is a chart comparing the two major large cap indexes over more than a quarter-century.

The chart above shows how closely DIA correlates to the SPDR S&P 500 Trust ETF (SPY). DIA actually had the edge for the very long term, back to the late 1990s and as recent as 2022. It gave up its lead in 2021, regained it, and then lost it again in 2023. You can see this in the orange spikes above. Did this mean that the economic and financial world has changed in some fundamental way? Probably not.

With a few minutes of rumination, we can all work out the reason for those orange spikes. This was the period during which the high growth Mag 7 tech stocks ran away with the market as a whole, pulling the S&P 500 up while its other 493 stocks were sometimes actually in the red. It's those spikes, counterintuitively, that make the case that DIA is likely to lead again in the not too distant future. It is likely to emerge relatively unscathed if the market hits a speed bump with major impact on the Mag 7. It all has to do with the difference in the way the Dow index and the S&P 500 are put together.

The Cap Weighted Approach Of The S&P 500 Is A Double-Edged Sword

In terms of its composition, the S&P is about as different as it gets. To start with, it contains pretty much everything except small caps and mid caps. In terms of cap sizes, the Dow and the S&P 500 are pretty much the same, but the Dow 30 contains only 6% the number of stocks. The Dow represents the market as a whole on the basis of a small sample but has nevertheless matched the market pretty closely.

The huge difference between the Dow and the S&P stems from its use of market cap weighting rather than price weighting. It is a list of 500 stocks (give or take one or two) ranked in importance from the stock with the largest cap weighting, currently Microsoft (MSFT) which recently displaced Apple (AAPL), down to the company with the smallest market cap. Each day after the market close, all stocks in the index have their cap weighting adjusted based on their prices at the market close. Thus change in the S&P happens daily, most often in small increments but with an underlying principle requiring the index to buy more of stocks that go up - sometimes a lot more over a fairly short period of time - and buy less or sell stocks which go down. This accounts for the fact that sectors and groups sometimes reach out-of-scale amounts and trends tend to overshoot on both the upside and downside. Right now, tech stocks appear to be overshooting on the upside while energy stocks, despite a couple of years of rallying, have over the long term overshot on the downside.

The changes in the Dow take place only occasionally, as the committee in charge decides to add a stock or several stocks while kicking out an equal number. There is no mechanism for buying more of stocks that go up or selling a few shares of stocks that go down. Only the absolute price change moves the value. The Dow portfolio thus has a stable number of shares in its stocks until a decision is made to effect a change. It has often been pointed out in recent years that the daily-updated cap weighting assures that all holders of funds or ETFs based on the S&P 500 index participate in rising growth companies. This is incontrovertibly true, although it requires a leap of faith to believe that companies which have risen in market cap will continue to rise in market cap. In other words, faith in long-term Momentum is essential. What you actually get from owning your share of the #1 stock by market cap (currently Microsoft) is the sum of its PAST history of success, not an ironclad promise of success in the future.

Past performance usually continues for a time and works to the advantage of cap weighted index holders as long as growth continues. There is a downside, however, due to the fact that the price of the leading stocks sometimes keeps running well beyond fair value. This is further exaggerated as index funds and ETFs are pressed to buy more shares in order to maintain a portfolio which precisely reflects market cap weightings. Thus, the growth leaders go from success to success until the process finally leads to excess. This has happened from time to time when a small group of stocks becomes extremely popular. When the trend eventually breaks and stocks with large market caps fall, they often fall hard and drag down the entire index. The following chart takes a magnifying glass to the last five years of the long-term chart above. It is more detailed but otherwise identical.

What you see in the above shortened version is the three orange spikes reflecting periods when the Mag 7 shot ahead of the other S&P 500 stocks and the Dow, with the spikes peaking at the end of 2021, early 2023, and possibly (though not certainly) late March 2024. In all three cases, the leading 7 high-growth tech stocks rose to be around 30% of the total market cap of the S&P 500. Note also that when the gap between the orange and purple lines is increasing the S&P 500 is outperforming and when the gap narrows the Dow is leading, actually taking the overall lead from 2021 to late 2022.

The short version is that in the long run the two indexes are heading to more or less the same place, but the Dow is doing it without the volatility. A full valuation correction in the Mag 7 is yet to come, and there is still the possibility that the Mag 7 and the rest of the S&P 500 in tow have a further and more extreme peak of valuation before a more powerful collapse in valuation. This may not happen immediately, as the evidence is that overvaluation does not on average lead to negative results within one year, but does so predictably over several years. In the long run, mean reversion is one of the most powerful tendencies of the market, and the 7-year forecasts of the famous GMO valuation prognostications emerged from studies indicating that 7 years was the period over which mean reversion generally asserts itself.

Mean reversion normally takes place around a trend. Take a quick glance at the long-term chart and note that the purple line of the Dow was above the orange line of the S&P almost all the time except for the brief period since the Mag 7 emerged and vaulted up to very high valuations, helped by the market cap methodology. The trend was positive for both DIA and SPY but worked a little better for DIA under normal circ*mstances.

The Dow's Selection Process Combines Change With Stability

The fact that the Dow committee which adds or removes stocks is made up of 5 journalists, two from the Wall Street Journal and three from S&P Global, makes sense for the Dow approach. Journalists are not money managers (except in their own personal portfolios) and are less likely to be carried away with a hot group of stocks or sectors. On the other hand, they are well-informed about the economy and markets and know a good bit of market history as well as seeing daily what goes on in the markets and what new things are emerging. This general knowledge is important because they don't just make selections of stocks to remove or add. They are also responsible for determining when the time has come to make changes.

But how do they make these decisions? The best way to answer is probably to look at several of their more recent decisions and try to reverse engineer their thinking. Here in reverse order are the most recent additions and deletions:

• 2024. Added Amazon (AMZN), deleted Walgreens Boots Alliance (WBA). The move was prompted by Walmart's (WMT) 3 for 1 split, which lowered its price and dropped it from #17 to #26 in influence on average. The committee dropped the Walgreens Boots Alliance, which was more narrow, and added Amazon to give fuller retail influence plus a high-tech element,
• 2020. Added Amgen (AMGN), Honeywell (HON), Salesforce (CRM), deleted Exxon (XOM), Pfizer (PFE), Raytheon (RTX). Amgen's pipeline probably looked more diversified than Pfizer's, Salesforce recognized the growth in customer relationship management as tech, and Exxon was dropped as it is essentially the same company as Chevron (CVX), also in the index and the energy sector seemed over-represented.
• 2018. Added Walgreen Boots Alliance, deleted General Electric, which had been in the Dow for over 100 years but was a fading business.
• 2013. Added Goldman Sachs (GS), Visa (V), Nike (NKE), deleted Alcoa (AA), Hewlett Packard (HPE), Bank of America (BAC). BAC was still struggling after the 2008-9 crash, while Goldman seemed OK, Alcoa, and Hewlett Packard were fading, Visa was an emerging superstar of the New Economy.
• 2012. Added UnitedHealth (UNH), now the #1 (remember "price driven") holding, dropped Kraft Foods. UNH is the biggest player in health care.
• 2009. Added Cisco Systems (CSCO), Travelers (TRV), deleted Citigroup (C), General Motors (GM). In the MBS Crisis Citigroup was a catastrophe while Travelers is a solid financial in the insurance area, owns a lot of bonds, and does copious buybacks. Cisco's sales and profits were still rising, General Motors was limping toward the exit.

Taken as a whole, the additions, and deletions updated coverage of the economy as a whole, purged companies with problems, and kept growth persistent. What's remarkable is that the committee achieves these portfolio goals with such a small number of additions/deletions, and sometimes none for several years.

Despite the small number of changes, the Dow has managed to keep the Dow Average roughly representative of the economy. The S&P 500 is currently 30% composed of technology, a number which is pretty obviously too high, at least for the present makeup of the economy. The Dow, by contrast, has only about 19% in tech, and even that number may be slightly on the high side. Financials are the largest sector in the Dow, constituting 23% while they come in a poor second of the S&P 500 at under 13%. Health care, consumer cyclicals, and industrials follow in that order in both indexes, but with the Dow percentages larger in each case. Health care may be hyped a bit by the fact that UnitedHealth has such a high price. Considering the above, ask yourself which average looks the most like the U.S. economy? Then consider the likelihood that the percentage of techs in the S&P 500 compared to the Dow must approximate the degree to which investors are currently overly enthusiastic. There is likely to be a period in the future when this excessive enthusiasm is corrected.

Why The Dow Is A Good Bet To Win In The Long Run

One of my favorite investment books has the subtitle Why The Tried And True Triumph Over The Bold And New. Its author is Jeremy Siegel, who is much better known for his classic study of stock returns published as Stocks For The Long Run. Published in 2005, the book about investing in the tried and true focuses strongly on reinvested dividends, while arguing in a chapter called "Growth Is Not Return" that investing in high-growth sectors can be a trap. Siegel also points to a study which says 97% of long-term equity returns derives from dividend reinvestment. The broad theme is that many companies which have been around for quite a while have many future years of good returns, and he backs his argument with page after page of data. It strikes me every time I read it that this argument should be stuck to my computer with a post-it note.

The methodology of the Dow Industrials reminds me of the personal task of putting together and maintaining a portfolio - especially the maintaining part. That's what the committee running the Dow does so well that individual investors who choose to create and manage their portfolios must be envious. I am one of those individual investors who uses individual stocks rather than indexes and I respect the skill with which the Dow committee maintains diversification coupled with solid growth and consistent returns.

The Dow has a head start when it comes to dividends. Its dividend yield is currently 1.80 compared to 1.32% for the S&P. That's an advantage of .48%, from which one must deduct the difference in expense ratio, .16 for the Dow versus .08 for the S&P 500. After that .08% cost advantage to the S&P, the Dow's net advantage is .40%, a small but significant amount.

The Dow's real advantage is the fact that the S&P's double-edged sword deriving from cap weighting is currently in the negative phase. The large influence of a single group of tech-oriented companies produces a vulnerability which can only be removed by a decline in their market caps and thus the market cap of the index as a whole. Add to that the continuing enthusiasm for these companies which borders on being definable as the "madness of crowds" and the S&P faces double jeopardy. It could always go on for another year or possibly two, especially if AI remains a powerful talking point, but further gains by the Mag 7 and similar stocks are most likely to result in a more painful decline once the fever breaks. Meanwhile, the Dow will continue to plod along with its portfolio created to match up with the major sectors of the economy.

Early and significant cuts in interest rates would support further advances of the tech superstars by justifying a higher P/E ratio. Lower rates mean a lower denominator for future estimated returns of growth companies. It would look a lot like the decade from 2009 through 2019 when the stocks of growth companies prospered well beyond their actual operational growth and retirees and income investors had a hard time finding safe income. "Higher for longer" rates, on the other hand, benefit solid value companies by setting a reasonable cost of capital for investments. For several weeks, there has been a tug of war between growth and value, easy to track in the relative performance of the Vanguard Growth Index ETF (VUG) and the Vanguard Value Index ETF (VTV). When VUG leads, the market is emphasizing growth thanks to low rates, while VTV suggests "higher for longer" due to persistent modest inflation. When the direction becomes clear, investors should take it as a major cue.

Recommendation

This is not a suggestion to go out immediately and buy the Dow Industrials ETF, or switch out of the S&P 500 ETF and into DIA. It's about the long-term probability that the Dow will outperform. The SA Quant system prefers SPY because of its lower risk (500 stocks rather than 30), higher Momentum (a statistical factor caused by the sharp rise in just 7 stocks), and lower expenses as mentioned above, although both have low expenses. This is the rare occasion that my view doesn't exactly coincide with the Quant Assessment for the reasons in this paragraph.

In either case, DIA or SPY, one might wait for the outcome of the growth versus value argument to become less opaque. If the top 10 stocks in SPY dropped sharply from the present 30% while the DIA had a much smaller drop, it might be a time for another close look at the two ETFs. If a decline in both took the shape of a large correction in mainly high-tech and AI oriented stocks, the overall market might perform somewhat like the dot.com collapse of 2000-2003, making the Dow a very good buy as it was in 2003. It then became the market leader for more than a decade and a half, as you can see on the first chart. It will tend to track growth in the economy as a whole rather than popular themes in the market.

Jim Sloan