Whereas the S&P and Dow consistently move in the same direction, they certainly do not do so by the same amount. One of them very often does better than the other for significant stretches of time. And this effect is not random, either. Put simply, the S&P tends to beat the Dow during more bullish periods and vice versa during more bearish periods.
In the late 1990s, for example, when equities generally were doing well, the S&P outpaced the Dow by 25 per cent over a three-year period. The effect was then dramatically reversed during the meltdown of 2000-02. Although both indices suffered painful bear markets, the S&P underperformed the Dow by almost 28 per cent. And this wasn't a one-off distortion arising from the technology bubble, either. The same relationship is in evidence most of the time going back to the mid-1930s.
It is not particularly surprising that the S&P and Dow should do better and worse at various times. Although both indices are made up from stocks in large US companies, they are constructed very differently. The S&P contains 500 stocks, the Dow just 30. An S&P company worth $50bn has 10 times the influence in the index as a stock worth $5bn. By contrast, the Dow is weighted according to stock prices, such that a stock trading at $100 has 10 times the influence as one trading at $10. The weightings of industries represented in each varies substantially, therefore.
From an investment point of view, tracking the S&P makes more sense. It represents a much broader spread of companies and is the benchmark for US large-cap equities. However, for tactical investors and traders, the choice should depend more on the outlook. If you are bearish, a holding in the Dow may lose you less than a holding in the S&P. Another possibility is to do a pairs trade, going long of one index and short selling the other.
Dynamic Trader chart
While I am still bullish on the medium-term outlook for US stocks, I accept that the recent shakeout could last a while longer. The current ratio between the S&P and Dow is 1344/12768 = 0.10526. In the event of ongoing weakness, the ratio could drop to 0.104 or even 0.101. In order to enter positions, I would wait until the ratio rallies a bit and then drops back through its 55-day exponential moving average, a strategy that worked quite well during last summer's equity market turbulence.
The obvious way to execute this strategy would be with a spread bet. Since we are seeking to capture a fairly small move of a few per cent, a spread bet would help to magnify the profits and losses on offer. It also enables us to take fairly small positions, perhaps taking total exposure of less than £13,000 or so.
