The Dodgy Dogs of the Dow and Other Backward-Looking Gimmicks

This is a gal named Bonnie showing some teenagers how to do a flying stretch on a trampoline. She bounced really high. Don't expect 2014's laggy stocks to automatically do the same. Photo by Hulton Archive/Getty Images.

Legend has it a guy with buckets of money once said: "The time to buy is when there is blood in the streets." ^[i] Words of wisdom, to a point! But some are taking them a bit too literally right now, suggesting folks plow into certain sectors or stocks simply because they've been hammered. Here is some friendly advice: Trading on past price movement alone isn't a winning strategy.

Consider Energy stocks, the current object of blood-in-the-streets lust. The MSCI World Energy Index is down -11.2% in 2014 (the full World Index, by comparison, is up 5.6%)^[ii], and a growing chorus is urging investors to pile in-because what goes down must surely rebound, and who doesn't love a bargain!

Trouble is, this ignores some key factors, like sentiment and the why behind Energy's slide. When markets punish sectors or stocks for the wrong or short-sighted reasons, you can find good bargains. Sometimes things just get hammered regardless of their longer-term potential. If you can identify and scoop them up, great-you'll be ahead of the fearful masses and ready to enjoy a nice ride higher once they catch on and bid prices back up.

This isn't what's happening in Energy right now. Energy stocks are down for a reason: Their revenues are price-sensitive, not volume-sensitive, making low crude oil prices a massive headwind. Everyone's paying attention to Energy now, with WTI crude sliding 45% year to date through 12/30^[iii] and Energy stock prices down. But Energy stocks have underperformed since 2011, as the shale boom kept prices in check, driving Energy earnings down in 7 of the last 11 quarters. The recent steep slide in prices only illuminates a longer-running negative, and with supply still high, prices aren't likely to skyrocket and restore rip-roaring earnings growth any time soon. Energy stocks might not keep falling, but they hardly look poised for the run of the century.

Plus, as another guy^[iv] once said, the time to be greedy is when others are fearful. We are hard-pressed to see much fear in Energy right now. On the contrary, it is darned popular! Not just with the bargain-pitching pundits. Energy sector ETF inflows hit record highs in December! Some would say this is the smart money seizing a contrarian opportunity, but that's a misnomer. Contrarianism just means thinking independently and not getting caught up in crowd mentality. The rush into Energy smacks of herding and later-stage bull market greed. The reasoning has nothing to do with fundamentals and everything to do with mean-reversion and Energy stocks' outperformance during the last decade. Few are looking forward, which means few see the headwinds facing Energy stocks for the foreseeable future. That makes them too popular. Not that we'd suggest avoiding the sector entirely-diversify! But a massive overweight seems unlikely to add much value looking forward.

Similar logic applies to another dog-chasing strategy gaining notice (as it does at the end of every year): The "Dogs of the Dow."^[v] This tactic, beloved in the retail brokerage world for its commission-generating prowess, involves buying the 10 DJIA stocks with the highest dividend at year-end (yay), assuming their prices are probably near troughs and will bounce the next year (yay). Now, we won't bore you by rehashing our many, many, many issues with the Dow itself-just know it's a broken, limited index. But that isn't the only reason the Dogs of the Dow is a broken, limited strategy. For one, it ignores the fact some or all the 10 could have fundamental problems or are in sectors with big headwinds over the foreseeable future. Bounces aren't guaranteed-you could end up concentrated in companies with limited potential, bypassing much better opportunities among the world's other 8,594 publicly traded firms.^[vi] That's probably why audits of the strategy show it's largely all bark.

Plus, it's too dividend-focused. Dow-dogs logic says DJIA stocks pay high dividends per share, and if you buy when prices are down, you get a higher yield and that is wonderful because yield rules! Except, yield doesn't rule. Dividends can be cut or eliminated at any time and, contrary to prevailing myth, DJIA stocks have eliminated dividends. Plus, if you're using your portfolio to generate cash flow, your total return, not yield alone, will determine how much cash you can kick off without raising the risk of depleting your portfolio prematurely. Price returns matter too, and high-dividend stocks don't always perform well. Investing for total return gives you much more flexibility than you'd otherwise have-selling shares now and then to raise cash for your daily needs isn't on the naughty list. It's ok.

In short: "Dogs of the Dow," like Energy bounce seeking, is a gimmick. The associated spin might sound tempting to mimic! But we suggest approaching it like a cynic. Cut through spin, weigh facts, and find the overlooked, real opportunities.

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