Passive investors who are reluctant to take on more risky equities often allocate a large portion of their retirement money into index funds, deferring to the widely popular S&P 500, which has fallen by over 10% during the market correction.
Why The Dow Could Be the Way to Go
The S&P 500 and the three other major benchmark indexes, the Dow Jones Industrial Average, the Nasdaq and the Russell 2000 have also hit new lows, declining by more than 10%. Among these indexes, the Dow has a “higher floor than the other broader indices” and will perform better during a bear market, said Robert Johnson, president of The American College of Financial Services in Bryn Mawr, Pa.
The Dow is selling currently at a lower price to earnings ratio of 15.44, down from 16.66 a year ago. Its average has been 14 to 15, and a normal range is between 10 and 20. The S&P 500 is 20.69, and the NASDAQ is 20.95. The P/E ratio is the current share price divided by annual earnings per share. When a company has a higher P/E ratio, it demonstrates a company and its stock are more valued, he said.
“In 2000, before the Internet bubble burst, the DJIA traded at a P/E in excess of 44,” he said. “If it were to trade near 10, that would imply that the Dow could fall by 36% or a level of 10,235.”
The Dow also has a higher dividend yield of 2.81% compared to the S&P 500’s yield of 2.36% and NASDAQ’s yield of 1.28%. The dividend yield is critical and a factor that should be considered, because it provides an “indication of the cash on cash return of the investment,” Johnson said. “Companies rarely decrease a dividend payment as it is interpreted by the market as a strong signal that the company is having financial difficulties. In today’s ultra low interest rate environment, stocks with healthy dividend yields stack up pretty well against bonds in terms of cash on cash return.”
P/E ratios are only one factor to examine an index and can vary, depending on interest rates, earnings growth prospects and the degree of investor risk aversion.
“We are near historical lows even with the recent Fed interest rate increase,” Johnson said. “For the long term investor, the stock market offers the best opportunity to build wealth.”
The Dow consists only of 30 companies weighted according to stock price and is not an “economic footprint of the economy,” nor is it a good reflection of what the market is doing, said Chris Philips, CFA and head of Vanguard Institutional Advisory Services. The Dow is not broad in scope compared to other indexes, and investors should focus more on the percentage loss instead of the number of points it has lost.
During these periods when a market correction is occurring, investors should ramp up their contributions to a 401(k) or make their annual IRA contribution at a time when volatility is high, said Edison Byzyka, chief investment officer for Hefty Wealth Partners in Auburn, Ind.
In addition, large cap equities have performed better than small caps, and it “may make sense” to sell a portion of large cap exposure to fund additional or new purchases into small caps, he said. This type of asset allocation shift has “proved positive when the market eventually enters into a secular bull market,” Byzyka said. “It’s more tied to upside and by selling some shares or an ETF of the S&P 500 index and buying Russell 2000, you are improving your chances for stronger gains once the market recovers.”
The majority of investors still “hate” to purchase stocks when they are on sale, he said.
“The issue is that retail investors tend to neglect low equity prices," Byzyka. “In the current scenario, where all major indices have significantly declined, it becomes a relative performance game.”