| By John Prestbo, MarketWatch
The easy, often-offered explanation for the Dow outperforming the S&P 500 is investor caution. There is truth there, but it's not the whole story.
The Dow Jones Industrial Average ($INDU) outperformed the Standard & Poor's 500 index ($INX) for much of this year so far, but now has lost its lead. And therein lies a tale.
Keeping an eye on the relative performance of these two much-publicized indexes has been a pastime of mine for many years. It tells me things about the market's mood and how investors are parsing economic and political developments.
Of course, there are jillion other indexes nowadays that deliver seemingly similar information. They tracking mega, super-large, merely large, upper midcap, lower midcap, small, micro-cap and even nano-cap stocks, not to mention growth, value and "core" stocks.
But because these two highly correlated indexes lie at the liquid heart of the market, the subtle dynamics of their relationship convey what I believe are important nuances.
For example, this year the S&P 500 jumped ahead on the spillover of exuberance about 2012's strong finish. But by the third week of January, as Congress reconvened and the Obama administration began its second term, the Dow caught up and surpassed it. That lead held until summer, as this chart shows:
The easy, often-offered explanation for the Dow outperforming the S&P 500 is investor caution. When the road ahead is filled with potholes and problems, according to this reasoning, investors seek refuge in larger stocks. There is truth in it, for the Dow seldom slips as much as the S&P 500 in market downturns.
But both the early-year leadership shift and the summer switchback occurred in the context of a rapidly rising market that gained more than 10% in the first quarter and almost as much in the subsequent six months. Investors have been pouring money into stocks, so caution isn't the right descriptive.
Moreover, indexes of midcap and small stocks have outraced those of large caps all year. That's relevant because the S&P 500, though dominated by a 96.4% weight in large stocks, nonetheless has that 3.6% remainder in smaller stocks. The Dow has no smaller stocks, which means the S&P 500 sometimes zips ahead on a tailwind when smaller stocks have caught investors' fancy.
Two factors contributed to the Dow's early supremacy. One was the nearly 27% drop in shares of Apple (AAPL) from the beginning of the year through mid-April. Apple is the largest stock in the S&P 500, and it isn't in the Dow. The other was heavy investor emphasis on dividend-paying stocks in the first half of the year -- which included all the Dow stocks but far from all the S&P 500 stocks.
The same two factors reversed themselves as the year wore on, contributing to the S&P 500 regaining the lead. Apple rebounded almost 20% from late June through the third week of September. And equity-income strategies began to fade as interest rates ticked higher in anticipation of the Federal Reserve tapering its Treasury bond-buying program.
Larger shifts were in the works, too. In the first half, investors were concerned about global economic growth, particularly focusing on a deceleration in China and recession in Europe. By August, China's problems didn't look quite so discouraging, and Europe -- at least parts of it -- was starting to show signs of life.
Meanwhile, the U.S. economic recovery continued. It remained slower than anybody wanted, but it trudged ahead steadily and even delivered a few modest surprises now and then.
In short, growth stocks look relatively less risky as summer ends, giving a boost to the S&P 500. Value stocks, which dominate the Dow, still appeal to many investors but have lost almost all their momentum advantage over growth stocks. The SPDR S&P 500 Growth ETF (SPYG) had close to a 5% performance deficit to the SPDR S&P 500 Value ETF (SPYV) at the end of July. As of Sept. 20 that had shrunk to 1%.
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