Fool.com: In This Corner... (Foolish Four) February 11, 1999

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In This Corner...
The Dow vs. The S&P 500

by Chris Rugaber (TMF [email protected])

Alexandria, VA (February 11, 1999) -- Our Foolish Four stocks seem to have stabilized a bit, and, in fact, are ahead of the Standard & Poor's 500 Index since we purchased them, returning 1.06% vs. the S&P's 0.1% (as of yesterday) -- not that any kind of one-day snapshot means much of anything in the long run. Still, it's nice to be ahead.

Today, I want to continue the discussion Ann Coleman began on Monday regarding the Foolish Four's performance in the last couple of years. Let's return to a fundamental question regarding the Dogs of the Dow: the performance of the Dow as an index vs. the S&P 500. If anything other than chance has contributed to the very recent underperformance of the Foolish Four, this might be it. After all, a strategy based on the Dow index might not fare so well if the Dow itself is in trouble.

According to Fortune, it may be. The magazine recently published an article titled "Could the Dow Become Extinct?" The basis for their concern is that in 1997 and 1998, the Dow badly trailed the S&P 500 in overall return. I wrote about this before, after a Barron's article in December also noted this recent and unusual disparity. But now it looks as if the doomsayers may be too hasty.

The Fortune article points out that while the S&P 500 and the Dow usually track each other -- the Dow returned 12.3% to the S&P's 12.7% over the past 30 years -- in the past couple of years the Dow has trailed the S&P by more than 10 points. Meanwhile, S&P indexing has taken off and investors have focused more on technology-related S&P stocks, such as Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %> and Dell <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DELL)") else Response.Write("(Nasdaq: DELL)") end if %>, rather than the Dow's industrial dinosaurs. The Fortune article also quotes several hotshot money managers and a token individual investor dismissing the Dow as irrelevant ("I don't really care what the Dow is doing," says one analyst at Morgan Stanley).

Nevertheless, let's take a closer look at the numbers. It's true that the S&P and the Dow, on average, track each other fairly closely. But this means little for any individual year. The numbers provide an interesting lesson about the difference between average performance and what actually happens in a particular year or two. Take a look at this table:

       Dow 30     S&P 500
     Total Rtn  Total Rtn  Difference
1974   -15.64%   -26.47%    10.83%
1975    44.25%    37.20%     7.05%
1976    29.36%    23.84%     5.52%
1977   -12.58%    -7.18%    -5.40%
1978     2.53%     6.56%    -4.03%
1979    11.34%    18.44%    -7.10%
1980    25.29%    32.42%    -7.13%
1981    -3.30%    -4.91%     1.61%
1982    19.80%    21.41%    -1.61%
1983    35.35%    22.51%    12.84%
1984    -0.12%     6.27%    -6.39%
1985    30.98%    32.16%    -1.18%
1986    21.87%    18.47%     3.40%
1987    15.72%     5.23%    10.49%
1988    13.78%    16.81%    -3.03%
1989    31.95%    31.49%     0.46%
1990    -9.14%    -3.17%    -5.97%
1991    30.36%    30.55%    -0.19%
1992    11.00%     7.67%     3.33%
1993    17.91%     9.99%     7.92%
1994     3.73%     1.31%     2.42%
1995    36.69%    37.43%    -0.74%
1996    24.32%    23.07%     1.25%
1997    22.33%    33.36%   -11.03%
1998    15.99%    28.70%   -12.71%
Average 16.15%    16.13%     0.02%

Start by looking at the averages: for the past 25 years, the Dow has returned an average annual rate of 16.15%, as opposed to the S&P's 16.13% -- only a 0.02% difference, even narrower than the 30-year number that Fortune mentioned. Pretty impressive.

However, take a look at the differences between the two indices each year: the Dow beat the S&P by more than 10 points in 1974, lost to it by over 7 points in 1979 and '80, whipped it by almost 13 points in 1983, walloped it by 10 points in 1987, and so on. While 1997-98 were unusual in that they are the only two consecutive years with double-digit spreads between the indices in the past quarter century, it isn't as if the Dow and S&P are normally within a few tenths of a point. Usually there are several points between the two.

In other words, despite the fact that the average returns for both indices are remarkably close, rarely has the closeness of those averages actually occurred in any one year. As you can see, only three times has the difference between indices been less than 1%, and only once has it been almost equal to the actual average: 1991's 0.19% difference. This distinction between the average return and any one year's return is a simple point that most of us may understand in the abstract. We may forget it, though, especially when we're worried about losing money.

Let's apply this principle to the Foolish Four. If someone -- such as the Motley Fool! -- tells you that the average rate of return of a particular back-tested stock strategy is x, it is quite unlikely that in any one year the returns will actually be x. Depending on the volatility of the strategy, the yearly returns may vary widely from x. This is where other statistics, such as standard deviation, come in and I start getting out of my depth. Ann Coleman addressed standard deviation more comprehensively in a November column.

In short, Fortune and the hotshot money managers may be jumping the gun. A couple of off years does not mean the average will trail the S&P 500 for all time.

However, there are legitimate questions to be asked about the Dow, such as whether it is overweighted in industrial stocks and underweighted in technology-related ones. Last time I wrote on this, I suggested that the idea that tech stocks were underrepresented in the Dow was "too simplistic," but now I'm not so sure. At least 15 of the current Dow stocks are essentially old-line manufacturing companies, while perhaps only three stocks could be considered high technology or telecommunications stocks -- IBM <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IBM)") else Response.Write("(NYSE: IBM)") end if %>, Hewlett-Packard <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HWP)") else Response.Write("(NYSE: HWP)") end if %>, and AT&T <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: T)") else Response.Write("(NYSE: T)") end if %>. We'll look at the structure of the Dow in greater detail next week.

Today's Stock Lists | 1998 Dow Returns

02/11/99 Close

Stock Change Last -------------------- CAT - 3/16 45.50 JPM +2 3/8 106.19 MMM +1 1/2 76.88 IP - 13/16 41.38

Day Month Year History FOOL-4 +0.49% 2.22% 0.07% 1.56% DJIA +2.03% 0.05% 2.13% 1.73% S&P 500 +2.49% -2.00% 2.34% 2.58% NASDAQ +4.16% -4.00% 9.71% 11.21% Rec'd # Security In At Now Change 12/24/98 24 Caterpillar 43.08 45.50 5.62% 12/24/98 14 3M 73.57 76.88 4.49% 12/24/98 9 JP Morgan 105.51 106.19 0.64% 12/24/98 22 Int'l Paper 43.55 41.38 -4.99% Rec'd # Security In At Value Change 12/24/98 24 Caterpillar 1034.00 1092.00 $58.00 12/24/98 14 3M 1030.00 1076.25 $46.25 12/24/98 9 JP Morgan 949.62 955.69 $6.07 12/24/98 22 Int'l Paper 958.12 910.25 -$47.87 Cash $28.26 TOTAL $4062.45

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