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Dow and emerging markets, overheated and overrated

Richard Loth

By the end of last week, the Dow Jones Industrial Average (DJIA) hit an historical record high of 11,850.21 – up from the previous peak in January2000 of 11,722.98. Accompanying this event, were articles during this same period in the Wall Street Journal and the New York Times reporting that investors continue to pour money into emerging markets.Both of these stories, while unconnected, need to be looked at carefully. The Dow’s performance was a huge media event. The folks at CNBC were beside themselves with exaggerated excitement. What does the Dow’s new high mean?The Motley Fool’s Alex Dumortier, CFA, summed it up nicely: “Nothing. Let me repeat – the record highs consecutively achieved by the Dow Jones Industrial Average on Tuesday and Wednesday means nothing of consequence.”Ironically, the oft-quoted Dow Jones index is the least important of indexes, i.e., market benchmarks that measure the performance of stocks. Dumortier rightly observes that “despite its popularity, it’s plainly unrepresentative of the national economy or the stock market.”Here’s why: Tracking only 30 stocks, the Dow has a very narrow focus. The New York Times’ Floyd Norris points out (Oct.7) that “the average [DJIA] can be deceiving, only 10 of the 30 stocks in the index are higher than they were then [Jan. 2000].” Secondly, the DJIA is weighted to favor the industrial sector (+/- 29 percent), whereas in the broader-based Standard & Poor’s 500 index this sector only represents about 12 percent.Lastly, the Dow is price-weighted while most other indexes are market-capitalization based. In the former, the weight of a stock is determined by price while in the latter it is by value, which is considered more representative. For example, Dumortier points out the biggest single factor in the Dow’s resurgence since 2000 has been Caterpillar. “The construction equipment maker was not even in the top 15 most influential stocks driving the the S&P 500.”Unfortunately, the financial news media weight their market-performance reporting so heavily with the results of the Dow Jones and the NASDAQ, which, with its preponderance of tech-stocks, is also not representative of the market as a whole. I would recommend that investors keep their eye onthe DJ Wilshire 5000 and S&P 500 indexes. Earlier this year (Mar. 30), I posed the question, “What do investors know about emerging markets?” I concluded then that it was very little. The situation has not improved very much, and may be getting worse. Hedge funds and conventional mutual funds continue to “search for new frontiers,” which sounds a little scary to me. Especially when these “new frontiers” include a number of countries in Sub-Saharan Africa!Alistair MacDonald (Wall Street Journal, Oct.6) quotes one fund manager’s rationale for this move: “It’s a combination of falling returns in all thetraditional emerging markets, cash flowing into hedge funds and high demands for commodities, combined with many of these countries getting their houses in order.” This logic strikes me as more self-serving than realistic.From 1986 to 1991, I spent a considerable amount of time in Africa on investment and finance projects, frequently visiting seven of the 12 countries mentioned. I have continued since then to stay informed. In my opinion, few, if any, of these countries have “their houses in order.”If you’re still hooked on this segment of the emerging-market game, consider this observation by MacDonald: “Most hedge funds [and fund managers in general] don’t have the staff, or the contacts, to research investments in Africa on their own,” i.e., they don’t have firsthand knowledge. How’s thatfor a confidence builder?If you’re into emerging-market investing, you might want to take a close look at what’s in your fund’s portfolio.Richard Loth is an independent registered investment adviser who runs Mentor Investing. He is a writer/publisher of investment education materials. His latest book, “Finding Investment Quality in a Mutual Fund,” is now available. E-mail inquiries to mentor@centurytel.net or call 328-5591.Vail, Colorado


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