Five Reasons the Dow’s New Highs Are “Bull-o-ney” (and What to Do About It)

dow-jones

While many investors want to celebrate the Dow hitting seven straight new all-time highs, things are not exactly as they appear.

Today I want to talk about why the hoopla surrounding the Dow is misplaced and what that means for your money. Then, I want to offer a few thoughts on what’s next for the markets.

Let’s start with the problems behind the Dow’s numbers. There are a few things you should know:

1. The Dow Jones Industrial Average is made up of just 30 stocks representing approximately 19.66% of the total market capitalization of the NYSE and Nasdaq, combined.

Despite the fanfare, this is hardly representative of the much larger picture, which is why I encourage investors to track the far broader and much more indicative S&P 500 instead.

2. The Dow is not inflation adjusted, so comparing it to previous price levels is like comparing oranges to bananas at best.

In fact, the Dow remains approximately 10% below its all-time inflation-adjusted high and would need to top 15,731.54 to really qualify for the record books, according to CNBC.

3. The Dow is price weighted, so big companies artificially distort the rise.

Take Microsoft Corporation (NasdaqGS: MSFT) and International Business Machines Corporation (NYSE: IBM), for example. The former is trading at $27.80, while the latter is trading at $209.14. According to the Dow methodology, this means that IBM has roughly 6.6 times the impact that MSFT does despite the fact that both companies share a market cap of approximately $233 billion.

4. The movement in the Dow doesn’t actually reflect consumers who feel poorer.

Average inflation-adjusted private sector earnings have been essentially flat for the last five years, and median U.S. household income continues to drop. It’s off 3.6% in January alone. Unemployment remains chronically high and inflation is hardly under control, as Team Bernanke asserts.

The last time the Dow was at these levels, regular gas averaged $2.75 a gallon. Now it’s $3.73. U.S. debt as a percentage of GDP was just under 40%. Now it’s nearly 75%. Consumer confidence was 99.5. Today it’s 69.6.

Further, 70% of Americans reported adjusting their spending plans to cope with the 2% payroll tax hike that came into effect January 1st, 2013.

5. The Fed’s meddling is creating artificially low interest rates and false liquidity.

Both are creating an updraft sustained by nothing more than an addiction to cheap money.

Speaking of which, the Fed is still pumping $85 billion a month into the economy on top of the $2 trillion it’s already spent. There’s a huge disconnect between the markets and the economy. The former is pulling ahead while the latter has more holes in it than Swiss cheese.

Ergo…despite being one of the most watched, commented upon and observed indexes in the world, the Dow is basically irrelevant.

So what can you do about it?

Plenty – “bull-o-ney” or not…

First, take profits. Most investors have been taught to let their winners run. Don’t misunderstand me – I am all for that. But ask yourself why professionals take money off the table whenever they’ve got big winners on their hands. The short version is they know that the longer a bull run continues, the higher the odds of a reversal. So they begin “lightening up” or systematically selling portions of their holdings while prices are rising. That’s why the markets have been soft early this week. You should do the same. The last thing you want to see is a big winner turn into a big loser.

Second, rebalance. After you’ve harvested your winners, redeploy the funds into segments of your portfolio that have fallen behind. Over time, this not only smoothes out portfolio volatility but ensures you are “buying low” and “selling high” which is, of course, exactly what you’re supposed to be doing.

Third, put new money to work in areas where there’s maximum chaos. I particularly like China, Malaysia, parts of Africa and the Middle East at the moment because the corruption, graft and insider trading we find so appalling are all in the news lately. This means that investors are shying away from otherwise quality companies and the superior upside that will come when they get their act together. The natural food industry is another great example. Growing backlash to chemicals and an increasing awareness of natural ingredients is causing little known stocks like National Grocer Vitamin Cottage (NYSE:NGVC) to pop. The horsemeat crisis in Europe will have a similar effect and create similar opportunities in the very near future.

Fourth, protect what you have with trailing stops. Given the economic backdrop, there is no excuse for not protecting your money in today’s markets. My favorite method is a simple trailing stop. What I like about trailing stops is that they offer a simple, unemotional, unbiased exit path when the markets begin to move against you. Variations include specific dollar-based stop losses, calendar stops and contingency orders. More sophisticated traders can use put options to accomplish the same thing.

Fifth, don’t chase performance. You are going to see a lot of headlines next quarter from companies anxious to tout great numbers and get their hands on your assets. Do your best to ignore them, while continuing to focus on a disciplined investing plan like the 50-40-10 Strategy I advocate as part of The Money Map Method. That way you can ignore the noise and concentrate on the opportunities in front of you.

And believe me, even at these lofty levels, there are still plenty to be had.

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