Dow Jones is uniquely vulnerable

Several headwinds are staring the industrial average straight in the face.

By InvestorPlace Oct 25, 2012 12:49PM

Stock market copyright Zurbar, age fotostockBy James Brumley

iplogoOK, all you blue-chip fans, if your simple solution to holding the best (and presumably safest) names in the market is simply owning a basket of the Dow Jones Industrial Average's stocks, you might want to rethink things soon.

While the group remains one of the easiest ways to apply a long-term buy-and-hold strategy, the unique makeup of the index might be putting it face-first into its fair share of near-term headwinds.

Generally, a market index like the S&P 500 or Nasdaq-100 is designed to be a cross-section of the overall market, usually inclusive of all the stocks that meet certain size criteria. Therefore, that basket of stocks will largely mirror the broad market's sector and size stratification.

The Dow isn't your typical index, though. Its holdings are hand-picked, and more often than not, its represented sector allocation is considerably different from the overall equity market's sector allocation. It's also stock-price weighted rather than market-cap weighted, meaning even the sector groupings within the index aren't actually a snapshot of the broad market.

Nine times out of 10, it doesn't matter. Right now, though, is that one time out of 10.

None of the Dow's most heavily represented sectors are well-positioned for much -- if any -- upside in the foreseeable future.

Breaking It Down

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The expandable table to the right sets up part of the pessimistic story. In no particular order . . .

Industrials: They might make up 20% of the Dow's total value, but they sure don't make up 20% of the U.S. market. Indeed, very few American companies actually "make" anything anymore.

That wouldn't be that big of a deal for the Dow Jones Industrial Average were it not for one thing: Its five components that are considered industrial stocks have been waving red flags for the bulk of third quarter's earnings season so far. Caterpillar (CAT), for instance, recently cut its full-year forecast for the second time this year, citing a measurable economic slowdown. 3M (MMM) also cut its full-year earnings forecast, hitting a big wall in Europe. Boeing (BA) is an encouraging exception, but the airplane maker can’t carry all the weight.

Financials: The financial sector actually is a bit underweighted in the Dow. Perhaps more important right now, however, is that financials have been one of only two sectors doing the lion’s share of the lifting for the Dow this year. That presents a problem, though, as many of these stocks have gotten a little ahead of the underlying companies, and have little room left to run higher. Add in the fact that Bank of America (BAC) is now facing a $1 billion lawsuit from -- and this isn’t a typo -- the United States government for mortgage fraud. That's 3.3% of the Dow right there, represented by a company that wasn't doing all that well to begin with.

Health care: The only other sector that's actually helped the Dow this year is also now strained and/or overbought as a result of doing so. And as you can tell, none of those pharma names are expected to light it up next year in terms of earnings growth.

Technology: Did any of these names do well (so far) this quarter? Microsoft (MSFT) fell short of Q3 earnings estimates, Hewlett-Packard (HPQ) is battening down the hatches in an effort to survive the looming PC-sales implosion, and International Business Machines (IBM) -- the rock of rocks within the technology world -- fell short of revenue estimates in Q3. It's the fifth consecutive time IBM missed the projected top line. It wouldn't be a huge deal, since we're getting used to the revenue miss, were it not for one thing -- this was the first time sales actually fell on a year-over-year basis. That's a big red flag. (Microsoft owns and publishes Top Stocks, an MSN Money site.)

Telecom: From a distance, AT&T (T) and Verizon (VZ) look perfectly healthy. In fact, they've both been so red-hot this year that many Dow investors might be wishing for a bigger telecom allocation for the DJIA. But neither name has left itself any wiggle room. Both trailing price-to-earnings (P/E) measures are in the 40's, and the forward-looking P/E ratios are in the teens as both telecom players expect the iPhone 5 to crank up wireless revenue while the landline business is bolstered by newly forged partnerships with several cable television companies. If any part of that optimistic forecast isn't met, though, traders aren't apt to hold onto stocks that are so richly valued. (In fact, they already might be fairly valued at their maximum earnings capacity for 2013.)

You get the idea, and it's not like energy or basic materials or consumer services -- at least not the ones in the Dow -- are in any position to help.

But wait. It gets even worse.

Technically Speaking …

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As if the Dow Jones Industrial Average's holdings weren't hitting a wall on their own, collectively, the index also is showing us a little too much technical weakness.

As of this week (and for the first time since July), the Dow Jones Industrial Average is trading beneath its 50-day moving average line (purple). As of Wednesday, the index is even putting some bearish pressure on the 100-day moving average line (gray). There's still a chance it could find support at the 100-day line and bounce out of this mess, but after falling under the key support line (black) that had been propping it up since July's bottom, why would the Dow find support here?

The last bastion of support/hope is the 200-day moving average line at 12,977 (green), which just happens to be intersected with the lower 50-day Bollinger band (orange) at this point in time. The bears have momentum, though, and if the 200-day line fails to act as support, it could be the beginning of a selling avalanche.

Add it to the list of things wrong with the DJIA right now.

Then again, considering a "normal" bull market correction is on the order of 9% -- and that we've only stumbled 4.2% thus far -- maybe it's just what the doctor ordered.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

More from InvestorPlace

Oct 25, 2012 1:53PM

I can’t believe I am saying this, I bought into “Hope and change” last time, really hoped President Obama was going to change things, couldn’t have been more wrong. This time I am going for “Change and hope” Mr. Romney knows more about turning a bad financial problem around than anyone, and dealing with the rich. It is what he does and like it or not he is very successful at it. Just hope he does the right thing for all of America, not just the rich and the GOP. America doesn’t need any more front men from either party. We need a real leader a president for all of America.

P.S Probably going to be wrong again wish I had another choice that was viable.       

Oct 25, 2012 1:42PM
Oct 25, 2012 1:30PM
Blah.  Blah.  Blah.  And here's my charts and my predictions of the future.  Predicting the future of anything is difficult.  Whenever someone is saying the market is ready to fall, it could easily be ready to rally.  And vice versa.

Stock markets do tend to rise over time, but decades-long periods of stagnation can easily occur with no real way to predict them.  Short-term market predictions often are totally meaningless. 
Oct 25, 2012 1:19PM
The "hopeium meme" of the last 4 years is just about totally exhausted.
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