Lately, the Dow Jones Industrial Average seems to be disconnected from the weaker overall economy, as it flirts with daily record highs. The fundamental reason why is rooted as much in math as it is in business and finance.
Keep in mind that the Dow Jones Industrial Average is also known as the Dow 30 – because it is only composed of 30 stocks. While it represents large companies in a range of industries, it is less than 0.5% of the more than 6,000 stocks available for trading between the NYSE, NASDAQ, and AMEX exchanges. It represents a sample of what are generally considered blue-chip stocks.
With only 30 stocks represented, it only takes a few stocks – a relatively small sample size, so to speak – to drive the market. That is exactly what is happening to the Dow right now. It is being driven up by three major performers: Merck (NYSE: MRK), Disney (NYSE: DIS), and especially Caterpillar (NYSE: CAT). Minus these three stocks, the Dow actually would be down overall in 2014!
Caterpillar is having a particularly disproportionate influence. Their stock is up almost 17% for the year so far, which doesn't sound so impressive until you consider that makes up over 50% of the Dow's entire 2014 gains. Should we expect Caterpillar's good results to continue, and what does it mean for the overall economy?
Caterpillar's success is as much rooted in global growth as domestic factors; approximately 61% of its business is in overseas sales. There is limited competition, with no rival that competes across all three main product lines (construction/earthmoving equipment, industrial engines, and heavy machinery for the mining industry). This gives them reasonable diversity to weather storms in any one field, but leaves them prone to geopolitical problems.
According to the first quarter earnings release, sales in the equipment and engine areas are expected to grow 5-10% whereas mining equipment has been revised downward to a 20% drop based on low order rates. Similar inventory issues took a huge toll in 2013, with sales losses of 15.5% based more on dealer inventory issues than losses to competitors.
Even so, Caterpillar continues with slowly rising profits since a sharp drop in Q4 of 2012 (excluding restructuring in Q1 2014), and has solid fundamentals and good cash flow.
Analysts are split on Caterpillar's outlook, with some attributing 2014 improvement mostly to replenishing the inventory reduction of 2013, and others predicting global stability and growth to drive Caterpillar sales higher still. Caterpillar's earnings report suggests that they have shouldered most of the burden of driving the Dow forward and will stay stable, but need someone else to propel the growth rate. Indeed, Caterpillar has dropped over 1% since the release of the recent sales figures.
How about Disney and Merck? NASDAQ recommendations show Disney as a strong buy with expected strong earnings growth through 2014 before slowing in 2015, but recent earnings revisions by analysts are mixed. Merck is less promising, still in the buy/hold range but with earnings expected to show a slight decline in 2014.
With the continued eleven-month upward trend of the Dow, it seems a correction is in order. There is no across-the-board growth in the Dow and individual stocks can only drive the market for so long. Yet many analysts are not concerned about a potential correction, believing it will be a temporary blip in a continuing bull market. Given the age of this bull, that may be a dangerous assumption.