Depending on which investor you ask, 2021 was either a great investing year, a mediocre year, or a terrible year.
Broader market returns were nothing short of phenomenal. Once again, the Nasdaq Composite (NASDAQINDEX: ^IXIC) and the S&P 500 (SNPINDEX: ^GSPC) outperformed the Dow Jones Industrial Average (DJINDICES: ^DJI), but all three had above average years. On the other side, many smaller growth stocks as well as some top-tier blue chips are still hovering around their 52-week lows. And ARK Invest CEO Cathie Wood’s famed flagship investment fund ARK Innovation ETF is down over 24% for the year.
That was 2021. Here are three charts that show why the Dow could keep underperforming the S&P 500 and Nasdaq in 2022.
A history of underperformance
Over the past year, three years, five years, and 10 years, the Dow has underperformed the S&P 500 and the Nasdaq, even when factoring in dividends.
Dow Jones Industrial Average
The market-outperforming stocks that the Dow does contain, such as Apple and Microsoft, are not weighted heavily enough to offset underperforming stocks in the Dow.
Another issue is that the Dow is a price-weighted index whereas the S&P 500 and Nasdaq Composite are market-cap-weighted. For the Dow, company weights are based on the relatively arbitrary price of the stock, not the actual value of a company. When Apple initiated a four-for-one stock split on Aug. 28, 2020, the value of the company (its market cap) didn’t change, meaning it kept the same weight in the S&P 500 or Nasdaq. But in the Dow, Apple suddenly had a quarter of its value. To offset the stock-split change, the Dow replaced Raytheon Technologies with technology-focused industrial Honeywell and replaced ExxonMobil with Salesforce.com.
The power of mega-cap tech stocks
Unlike the Dow, which chooses stocks that reflect the entire U.S. economy, the S&P 500 and Nasdaq have become increasingly concentrated in technology over the years because technology has produced the bulk of market gains since the financial crisis.
The chart below shows the market caps of the seven largest U.S. companies, which also happen to be stocks on the Nasdaq and S&P 500. Yet only Apple and Microsoft are Dow constituents.
Even more shocking, consider that the total market cap of these seven stocks is $12.03 trillion, which makes up nearly half of the $25.4 trillion market cap of the entire Nasdaq composite. These seven stocks have all beaten the S&P 500 and the Dow over the last three, five, and 10 years. In short, the bulk of the Nasdaq is in market-beating mega-cap stocks. And for that simple reason, it’s beating the S&P 500 and the Dow.
How the Dow could outperform other indexes
The Dow’s historical underperformance doesn’t necessarily mean the trend will continue. The simplest way for the Dow to begin outperforming the S&P 500 and Nasdaq is if the market shifts from growth to income and value.
The Dow might not have as many big-tech or high-growth names as other indexes. But what it lacks in these categories, it makes up for with a lower average price-to-earnings (P/E) ratio and a higher average dividend yield.
Dow Jones Industrial Average
Average dividend yield
Dow companies like McDonald’s, Nike, and Coca-Cola are industry leaders and highly profitable, with the balance sheets to get through recessions and expand during good economic times. The market has been in growth mode since the financial crisis, a trend that’s been fueled by low interest rates and the global expansion of mobile payments, software, e-commerce, smartphones, social media, and a slew of other trends that benefit growth companies like Apple and Microsoft. If interest rates rise, or growth slows for any number of reasons, then investors could rotate out of sectors like technology and into consumer staples, industrials, healthcare, or other stodgier sectors known for cheaper valuations and higher dividends.
Indexes aren’t that important
Hopefully, this article gives you a better understanding of the composition of the Dow versus the S&P 500 and the Nasdaq, and the power that big tech stocks have had on the market for over 10 years. Although investors often measure their performance against the broader indexes, the reality is that it doesn’t really matter in the grand scheme of things.
Rather, it’s best to choose an investment style that helps you sleep at night and hit your long-term financial goals. For many investors, a 5% annual return in low-volatility value stocks is just fine. For investors with a longer time horizon, investing in higher-risk/higher-reward opportunities is OK because, in the event of a catastrophic loss, they still have plenty of investing years ahead to make up for the losses.
Investing is a very personal endeavor, as we all respond to gains and losses differently. Finding a strategy that works for you is more important than if the Dow beats or doesn’t beat the S&P 500 or the Nasdaq next year.
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