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Stock Watch

Dow 20,000: Stock Market Milestone Is Tantalizingly Close

The ride getting there may be bumpy, but the Dow Jones industrial average could be heading toward a major milestone: cracking 20,000 for the first time in its 120-year history.

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From its November 28 close of 19,097, the Dow needs to climb just 4.7% to reach 20,000. Given the bullish sentiment now coursing through the market—the Dow has jumped 4.2% since the presidential election—that looks achievable over the next 12 months, if not sooner.

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The Dow’s roster of 30 stocks includes many of America’s biggest companies, including Apple (symbol AAPL), ExxonMobil (XOM) and JPMorgan Chase (JPM). Wall Street analysts expect the 30 Dow constituents to bolster earnings by an average of 11% in 2017, according to research firm Factset. That puts the Dow’s price-earnings ratio at 16 times estimated 2017 profits, slightly below the P/E ratio of 17 for Standard & Poor’s 500-stock index, according to J.P. Morgan Asset Management.

More important than the Dow’s P/E ratio—which could rise a bit without getting into bubble territory—are other factors that could help lift its stocks, says Jim Paulsen, chief investment strategist at Wells Capital Management. Investors now appear to be shifting toward shares of economically sensitive companies: manufacturers, financials and producers of raw materials. The Dow tilts more heavily toward these firms than the S&P 500 does; industrial concerns alone account for nearly 20% of the Dow (compared with 10% for the S&P 500). Improving economic activity should lift these firms. The U.S. economy expanded by 3.2% in the third quarter of 2016, a growth rate that could hit 3.6% in the fourth quarter, according to the latest “GDP Now” forecast by the Federal Reserve Bank of Atlanta.

Many Dow stocks could also get a lift from foreign economies. Global growth trends are now picking up, says Paulsen, with manufacturing data and other economic indicators strengthening in China, Japan and countries in the eurozone. If those trends continue, Dow components such as Boeing (BA), Caterpillar (CAT), General Electric (GE) and United Technologies (UTX) should all see gains in foreign sales and profits.

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One potential threat to these firms would be a rising dollar (because sales and profits earned in foreign currencies would be worth less when converted to greenbacks). But despite the dollar’s recent ascent—up about 4.7% since November 4—Paulsen thinks it’s unlikely to climb much higher. Since 1970, whenever the Federal Reserve has raised short-term interest rates, the dollar has ended lower than it was before the Fed started its rising-rate cycle. The reason: The Fed increases rates when inflation expectations are climbing, and higher inflation erodes the value of the dollar. “Everyone is betting the dollar will go higher because the Fed will raise rates,” he says. “My bet is the dollar doesn’t break out of its current trading range.”

Before you pull out the party hats for Dow 20,000, it’s worth keeping a few caveats in mind. For one, stocks overall appear to be rising on hopes of lower corporate tax rates, higher government spending, new trade policies that favor U.S. businesses and sweeping cuts in regulations—all of which could help boost the economy, corporate sales and profits. But President-elect Donald Trump and the new Congress haven’t even been sworn in, let alone had a chance to hash out major changes in U.S. spending and tax policies. If the new normal falls short of expectations, stocks could be in for a sharp decline.

Furthermore, the Dow isn’t representative of the broad U.S. stock market. Because it weights stocks by share price rather than market value, the index contains a quirky mix of companies. Goldman Sachs (GS), 3M (MMM) and IBM (IBM) occupy the top three spots in the Dow, with Goldman (possessing the highest share price) clocking in at a 7.5% weighting and the others at 6.2% and 5.9%, respectively. Yet the largest U.S. company by market value, Apple, receives only a 4% weighting. The Dow excludes new-economy tech giants such as Alphabet (GOOGL), Google’s parent, as well as Amazon.com (AMZN) and Facebook (FB). Also missing is the nation’s fourth-largest U.S. company by market capitalization: Warren Buffett’s Berkshire Hathaway (BRK.B).

This stock mix has helped the Dow beat the S&P 500 this year. Through November 28, the Dow had returned 12.3% (including dividends), compared with a 9.9% gain for the broader-market index. But the Dow is playing catch-up. The index trailed the S&P 500 by an average of 3 percentage points from 2012 through 2015. For the Dow’s winning streak to continue, a handful of its biggest stocks will need to keep beating the broader market.

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Even if the Dow did rally to 20,000, it wouldn’t necessarily be the star of the U.S. market. Economist Ed Yardeni, a veteran Wall Street strategist, expects the S&P 500 to reach a range of 2,300 to 2,400 in 2017. At 2,350, that would produce a 6.7% gain from the November 28 close of 2,202. But “that could happen sooner rather than later if the Trump melt-up continues,” says Yardeni. Some analysts also expect small-company stocks to outperform large-caps. The Russell 2000 index, which tracks stocks of small U.S. companies, has gained 18.6% this year (through November 28). That winning streak could continue because small-caps may benefit more from lower corporate taxes and potentially protectionist U.S. trade policies than large multinationals.

Even more attractive are foreign stocks, says Paulsen. The European Central Bank, Bank of Japan and People’s Bank of China—the country’s central bank—have all cut interest rates and taken other measures to boost economic growth. What’s more, none of them is planning to hike rates, which stands in sharp contrast with the Federal Reserve, which could raise rates throughout 2017 if U.S. economic growth and inflation forecasts continue to climb. Looser monetary policies should help lift overseas economies and provide a tailwind for their stock markets.

Foreign stocks are generally cheaper than their U.S. counterparts, too. And foreign companies’ earnings growth rate remains about 40% below the average growth rate since 1970, compared with earnings growth being 10% below average for U.S. firms. That offers more room for improvement for foreign firms. “To me, the issue is where do you want to invest, rather than whether the Dow will hit 20,000,” Paulsen says. “Over the next year, you may be better off in foreign stocks.”

If you want to invest in the Dow, the most efficient way to go is with an exchange-traded fund. SPDR Dow Jones Industrial Average ETF (DIA, $190.78) closely tracks the index’s performance and charges an annual expense ratio of 0.17%.

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Alternatively, you could duplicate the quirky Dow yourself, buying an equal number of shares in all 30 stocks. For a bit less than $11,200, you could buy four shares of each stock. Using an online broker that charges $7 per trade, you would pay commissions of $210, or 0.19% of the investment. That would be a bit costlier than the annual fee charged by the ETF, and you would need to tweak your holdings whenever S&P Dow Jones Indices changes the average’s composition. But that happens infrequently; the last adjustment was in 2015, when Apple replaced AT&T (T). Before that, the Dow dropped three companies and added three others in 2013.

Over time, your annual expenses would likely be lower than the ETF’s, enabling you to capture more of the Dow’s total return. A few years from now, the Dow may have even left the 20,000 mark in the dust.

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