Record volatility in stocks pushed investors to the safety of large companies and handed the Dow Jones Industrial Average the best risk-adjusted return since the bull market started in 2009, the first time the gauge has led a comparable recovery.
The BLOOMBERG RISKLESS RETURN RANKING shows the 30-stock Dow rose 5.9 percent from the market low on March 9, 2009, through yesterday when adjusted for volatility, the highest out of nine American benchmark equity gauges. Never before has the measure led a rebound in the three years after a market bottom, according to data compiled by Bloomberg and going back to 1966.
Investors, reeling from the widest price swings in equity market history in 2008, sacrificed returns for the stability of large companies such as Caterpillar Inc. and their global revenue streams, as selloffs in May 2010 and last August cast doubt on the recovery and kept volatility elevated. Options show investors are betting the Dow will continue to be stable as Europe’s sovereign-debt crisis, the growing U.S. government debt and a slowdown in emerging markets overshadow the best stock-market start since 1998.
“The market is still a little skittish, still a little worried about events overseas, whether it’s Greek debt or Iran’s nuclear program,” John Carey, who helps oversee about $220 billion at Pioneer Investments in Boston, said in a telephone interview. “In that kind of environment, there will continue to be an interest in companies that are more stable, better financed, more internationally recognized.”
Beating Small Caps
The Dow beat the Standard & Poor’s 500 Index, which returned a risk-adjusted 5.2 percent in the period, and the S&P Midcap 400 Index, the second-best gauge with a gain of 5.7 percent. While the Dow had only the seventh-highest total return with 112 percent, its volatility was the lowest over the almost three years. The index rose 0.6 percent to 12,837.33 today.
The last time stocks recovered from a market bottom, after the Internet bubble a decade ago, the midcap index had the highest risk-adjusted return and the Dow was last.
The risk-adjusted return is calculated by dividing total return by volatility, or the degree of daily price-swing variation, giving a measure of income per unit of risk.
While the S&P SmallCap 600 Index had the biggest total return during the three-year bull-market, climbing 150 percent, the measure’s volatility was 52 percent higher than the Dow’s, according to data compiled by Bloomberg. The Russell 2000 Index had the third-highest returns, advancing 139 percent. Its volatility was the highest out of the nine gauges, making it the index with the lowest return after taking into account price swings.
The ranking also included the Russell 1000 and 3000 indexes, as well as the S&P 1500 Composite Index and the Wilshire 5000 Total Market Index. The Nasdaq Composite Index and Nasdaq-100 Index weren’t included because they have weightings of 50 percent or more in technology shares. None of the gauges in the analysis gave more than a 24 percent weight to any industry group, according to data compiled by Bloomberg.
Traders’ expectations for swings in the Dow versus the Russell 2000 during the next three months have fallen to the lowest in 10 months. Implied volatility for three-month options on the Dow fell to 0.61 times that of the Russell 2000 on March 2, the lowest level since April 2011.
Caterpillar, the largest construction and mining-equipment maker, surged 343 percent since the bull market began and had the best-risk adjusted return in the Dow, at 10 percent. American Express Co. was next with 9.3 percent as prices of its shares increased almost fivefold. DuPont Co. was third, posting gains of 210 percent with a risk-adjusted return of 7.9 percent. All companies in the 30-stock gauge have posted positive risk-adjusted returns since March 2009 except Hewlett-Packard Co., which fell less than 0.1 percent.
“When the bull market started, people were fixated on global growth and some of the larger names were very appealing,” Mark Bronzo, who helps manage about $24 billion at Security Global Investors in Irvington, New York, said in a telephone interview on Feb. 28. “That helped drive the Dow.”
Caterpillar, which is based in Peoria, Illinois, got 64 percent of its revenue from outside the U.S. in 2011. That figure was 30 percent for American Express, 65 percent for DuPont and 68 percent for McDonald’s Corp.
In the three years after the Russian financial crisis and the collapse of Long-Term Capital Management LP, and again following the end of the dot-com bubble, the midcap index outperformed the other gauges by risk-adjusted return. It returned 6 percent in the three years after stocks hit a low in October 2002. The Dow had the lowest risk-adjusted return during the period, advancing 3.5 percent.
The S&P MidCap 400 had the best performance from the start of the bull market on March 9, 2009 through April 29, 2011, returning 6.7 percent. In the next four months, the Federal Reserve’s second round of quantitative easing ended, Europe’s debt crisis intensified, and the U.S. lost its AAA debt rating.
The Dow had the best return from the 2011 peak on April 29 through its low on Oct. 3, as about $13 trillion was erased from global equities.
“Dow companies are less risky than the market,” Kevin Shacknofsky, who helps manage about $5 billion for Alpine Mutual Funds in Purchase New York, said in a March 1 e-mail. “They are large and have strong balance sheets. Because of their size and diversification of products and geography, their earnings are less volatile.” He said the companies’ global business will continue to support earnings, and low interest rates will draw investors to their dividends.
Since U.S. equities have recovered from their October lows, the Russell 1000 Index has posted the highest returns after taking into account price swings, advancing 1.1 percent.
‘A Little Weary’
With the Dow up 4.4 percent this year and the S&P 500 having gained 6.8 percent, investors may increasingly pay for growth if the market stabilizes further, according to Thomas Garcia, head of equity trading at Santa Fe, New Mexico-based Thornburg Investment Management Inc.
“Investors were a little weary of the environment we were in and they can get some downside protection in the bigger companies,” Garcia, whose firm oversees about $80 billion, said in an e-mail on March 1. “The more investors feel comfortable with the economies of the world, the more they are willing to take risk in some of the smaller companies.”
Some of the best-known investors have doubts the rally will continue without hiccups.
Paulson & Co., the $23 billion hedge fund run by John Paulson, told clients in its year-end letter last month that Greece may default and trigger the breakup of the euro, leading “to a European banking crisis on par or worse than the world suffered in 2008 when Lehman Brothers failed.”
Seth Klarman, founder of Boston hedge fund Baupost Group LLC, told clients that while market swings provide buying opportunities, investing in 2011 felt like “playing a great hand of cards in the basement of a condemned building filled with explosives during an earthquake.”
“We are truly in uncharted territory,” Klarman told investors in a letter dated Jan. 31. “A crisis erupts, followed by intervention that staves it off for the moment. Another crisis, another quick fix, or vague promises of one.”
That lack of direction is helping the Dow. Its average price intraday swing in 2011 was 0.95 percent, according to data compiled by Bloomberg. That compares with the S&P 500’s average of 1.04 percent and Russell 2000’s 1.51 percent, the data show.
Seventeen of the 30 largest U.S. stocks are in the Dow. The 115-year-old index’s current members include General Electric Co., the oldest member of the gauge, Exxon Mobil Corp., the world’s second-biggest company by value, and International Business Machines Corp., the member with the highest weight in the measure.
Cisco Systems Inc. and Travelers Cos. joined the Dow in 2009 as Citigroup Inc. and the predecessor of General Motors Co. exited. Kraft Foods Inc. replaced American International Group Inc. in September 2008. Since the index first topped 10,000 a decade ago, there have been 12 changes to its components.
Dow profits are projected by analysts to increase 7.4 percent to $1,043.81 in 2012. The measure’s valuation increase since the equity market’s bottom in March 2009 is one of the lowest. It’s trading at 13.1 times earnings, 9.9 percent higher than it was in March 2009. The S&P 500’s valuation rebounded 36 percent in the same period to 13.8 times profit. The Russell 1000’s valuation has climbed 31 percent.
Investors may be lured to larger companies that tend to pay higher dividends, as the 10-year Treasury note’s yield remains near a record low 1.72 percent, according to Carey and Garcia. The Dow’s payout rate is 2.55 percent, compared to the S&P 500’s 2.03 percent rate and the Russell 2000’s 1.51 percent rate, according to data compiled by Bloomberg. AT&T Inc. pays the highest dividend in the Dow with 5.73 percent, followed by Verizon Communications Inc. at 5.17 percent, the data show.
“The Dow companies are seen as secure blue chips, and while we’ve had a bull market, it’s also been a period characterized by a few near-death experiences and sharp downdrafts,” Carey said. “I can’t really predict one index performance versus another, but the Dow has proven itself to be a bad index to bet against.”