Dogging the DOW, Debunking Myths

October 29, 2017 11:03 AM
Many traders avoid the 30 Dow components based on long held market assumptions. But are they missing out on opportunities?

Analysts seem to look down at the components of the Dow Jones Industrial Average in every way imaginable. The Dow components are an interesting group because they have extraordinary liquidity. At the same time, they are mature companies. Conventional market wisdom says that mature companies are unlikely to grow as fast as newer companies, which have unique products and more available market share to capture.

Sometimes we submit to conventional wisdom without looking at all the facts. It is easy to decide, in advance, that the gain probably won’t be worth the effort. But the most valuable tool for a trader is curiosity, and the desire to seek proof rather than simply accept conventional wisdom. An abundance of curiosity led us to research whether buying or selling the strongest Dow components, and simultaneously doing the opposite with the weakest, would yield an interesting result. This simple approach to arbitrage should reduce risk more than it reduces returns.

This research included a look at some of the established strategies for the Dow, and discovered the truth about them. The period evaluated is from 2004 through March 2017. While the Dow can be traced back more than 100 years, results from 2004 are more relevant now.

What we discovered were multiple myths regarding the Dow, as well as some new approaches to trading its components.

Myth 1: Large Companies Can’t Grow at the Same Rate as Smaller or Newer Companies
This is a difficult statement to prove or disprove because smaller companies can post great returns or they can fail. Generally, we can say they have fatter tails. We decided to compare the 30 Dow stocks with the rest of the S&P 500 (see “Dow 30 vs. broad market,” below). When adjusted to 100 at the beginning of 2004, both the Dow exchange traded fund (DIA) and the SPY performed nearly the same. We can see that the Dow stocks represent about 25% of the S&P total capitalization, which still leaves enough room to separate the performance of one index from the other.

Our conclusion is that big companies can perform as well as smaller ones. Of course, it doesn’t hurt that Apple (AAPL) is part of the Dow, and that some smaller companies can implode, but if we allow exceptions to every rule, there is no way to draw any rational conclusion.

Myth 2: The Dogs of the Dow Take Advantage of Rotation
The Dogs of the Dow was popularized by Michael O’Higgins in Beating the Dow (1992). In those rules, you bought the 10 highest yielding Dow stocks on Jan. 1 and held them for the rest of the year. For the period 1973 through 1989, that method would have beaten the average return of the Dow by 6.8% per year. However, in 2017, the current thinking is that high yields mean low returns. After all, why pay shareholders a high yield when the stock is soaring, like Apple? We’ll use the concept that a high yield generally means lower returns, and take an easier path analyzing the Dow.

Buying the 10 Worst Performers in the Dow
The Dow members are all substantial companies. When they want to attract more buyers they raise dividends. They are always trying to improve their market share by introducing new products or some new innovation. For those reasons, it is possible that the worst Dow stocks might rotate upwards in their returns.

“Contrarian approach,” (above) show the results of buying the 10 Dow components with the worst returns, then rebalancing annually (every 252 days). Based on a $200,000 investment, each stock is allocated $20,000 and the position size is $20,000 divided by the price at the beginning of each year, a simple way to get volatility parity.

The results show a drawdown of about $30,000, or 15%, from 2008 through 2010, far less than the drawdown of the whole market. Otherwise, the net return was only slightly more than $15,000. We can calculate the simple return as $15,000/200,000 divided by 12 years, or about 62 basis points. Not a return we would like but could be useful when viewed as a hedge.

The results of DIA and SPY show DIA with a return of 7.65% and an annualized volatlity of 17.8%, and SPY with a return of 7.55% with an annualized volatility of 19.1%. DIA’s risk/reward ratio is 0.429 while SPY’s is 0.395. Both are far better than buying the 10 worse performers of the Dow. While we can’t speak for the past, this period shows once a dog, always a dog.

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