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.”
S&P 500 Is Broader
Since S&P 500 focuses on the 500 largest U.S. companies, it is a “a great core” position for any diversified portfolio. It can be purchased cheaply and provides exposure to a large number of stocks, said Paul Jacobs, chief investment officer of Palisades Hudson Financial Group in Atlanta.
“The U.S. stock market has outperformed foreign markets lately and there is a risk that it may underperform in the future, due to the cyclical nature of investing,” he said.
The S&P 500 provides a much broader perspective on the “overall health” of the stock market, said Philips, but investors should still focus on the percentage it has lost or gained instead of the number of points.
It is an “incomplete” index because it only focuses on large cap companies and there are 3,000 to 4,000 public companies overall, including mid and small cap ones, he said.
“The U.S. stock exposure is broader and it is a good place to start for investors,” Philips said. “It is also a better barometer of the health of the marketplace.”
Nasdaq, Russell 2000 and Other Indexes
The Nasdaq has historically been very “tech centric” and can be an effective barometer of tech stocks and more volatile names, he said. A better proxy for U.S. equities is the S&P 500 for retirement portfolios, Philips said.
The Russell 2000 (RUT) and S&P 600 (SP600) indexes focus on U.S. small cap stocks, and the stocks of small companies are riskier than more stable large cap companies, Jacobs said. Over time, small cap company stocks have tended to outperform large cap stocks on average.
“While we don't recommend investing a huge portion of your portfolio into small cap stocks, we think they are great for adding diversification and boosting returns over the long-term, he said.
A broader index such as the Russell 3000 (RUA) consists of small, mid and large cap companies and combines the S&P 500 and Russell 2000 or the Dow Jones U.S. Total Stock Market Index, which contains 2,500 stocks, are broader slices of the marketplace and good starting points for investors, said Philips.
Maintaining exposure to foreign large company stocks such as through the MSCI EAFE and the FTSE Global All Cap ex U.S. Index is critical, because a portfolio will be more diversified and since the investments are “denominated in foreign currency, the currency exposure will diversify your portfolio even more,” said Jacobs.
“While many foreign countries have underperformed the U.S. market over the last few years, we continue to recommend foreign stocks,” he said. “U.S. stocks cannot outperform foreign stocks forever and in the future we expect the pendulum to swing back and forth with foreign stocks doing better than the U.S. in some years and worse in others. By diversifying and rebalancing as time passes, this will lead to the best possible outcome for investors.”
Despite the uncertainty of the future returns of the indexes, investors should “remain confident that stock indices will outperform bonds over the long term,” Jacobs said.
“Investors get the best results by staying disciplined, staying diversified and keeping costs low,” he said. It's difficult to call a top or bottom with an investment, but a disciplined investor doesn't have to do this ever.”
Swapping out one index over another is not recommended, said Philips.
“Investors should not be picking a bottom or rotating into another sector or asset class,” he said. “If you do, you are chasing your own tail and always trying to play catch up and that strategy does not work. Invest as broad as possible.”
Rebalancing a portfolio periodically is more important by reducing exposure to investments that have outperformed and adding to investments that have underperformed, said Jacobs.
“The goal of any investor should be to buy low and sell high and rebalancing helps you accomplish that,” he said.
Being emotional after declines in a portfolio have occurred results in investors buying high and selling low.
“This is dangerous and can lead to large, irreversible losses,” Jacobs added.