Diamonds Shine Brightly During Slowdowns

With signs of an economic slowdown increasing -- the latest being Wednesday's ISM report and Tuesday's weaker-than-expected consumer confidence and Chicago PMI data -- many investors are looking for a way to navigate the apparent downturn. So it might seem counterintuitive that the Dow Jones Industrial Average, with its cyclical-sounding name and which recently has been hitting new high after new high, would be the index to beat.

But, in fact, that may be the case, making the Diamonds (DIA Quote), the ETF that tracks the Dow, an excellent choice to ride out any economic downturn. I believe this for two reasons: fundamentals and valuation.

Much is made of the notion that the recent rally has been narrow, and that the broader S&P 500 is still some 10% below its all-time high, as if to imply that the S&P is therefore a better value. But were it not for the technology sector (which represented roughly 20% of the S&P 500 back in 2000) , the bellwether index would be hitting new highs. And, in fact, since the bear market lows of early 2003, the S&P 500 is up 70%, compared with 60% for the Dow.

Regardless, too much emphasis is put on past performance in our opinion. What really matters for investors is the outlook going forward. When buying a single stock, you'd look at fundamentals, such as earnings estimates, and valuation multiples, such as the price-to-earnings ratio, and compare them to other stocks'. A basket of stocks -- i.e., an ETF -- should be no different.

I don't believe recession is in the cards (at least not next year), but how should ETF investors position themselves for an economic slowdown, regardless of its severity? These four fundamental factors could make a difference:

High exports as a percentage of sales, to shield companies from a U.S. economic slowdown and any potential U.S. dollar weakness;

Positive estimate revisions, as proof that abstract economic worries are not translating to weakness on the ground;

Low exposure to the consumer discretionary sector -- not because consumers are doomed, but because from an analysis of the Consumer Discretionary Sector SPDR (XLY Quote), estimates are far too optimistic and P/Es are too high;

Reasonable valuations.

The table below shows the results of this screen for a group of four broad-market ETFs:

Sensitivity to the Slowdown The Dow ETF looks best prepared for a weaker economic environment
	Exports (% of Sales)	Revisions (vs. 3 months ago)	Consumer Discretionary (% of total)	P/E (2007 Est. EPS)
Dow Industrials (DIA)	44.6%	0.8%	12.70%	14.1
S&P 500 (SPY)	28.7	-0.4	10.1	14.5
S&P Mid-Cap 400 (MDY)	21.5	-1.1	27.6	15.4
Russell 2000 (IWM)	17.4	-2.9	31.1	20.0
Source: AltaVista Independent Research, Inc.

The Dow Diamonds fare well in this analysis because of high exports, positive revisions (i.e., current EPS estimates are 0.8% above where they were three months ago, while estimates for each of the other indices has fallen), low overall exposure to the consumer discretionary sector and the cheapest P/E of the group.

At the opposite end of the spectrum are small-cap stocks in the Russell 2000, which ranks poorly on all the fundamental measures, sports a lofty P/E of 20 times next year's estimated earnings and has nearly one-third of its holdings dependent on the fortunes of the consumer discretionary sector.