Why the Dow is at Record Highs

Investors are fleeing to the citadels of the blue chips...

IN THE olden days – let's say back in the 13th century during the Mongol invasions of Europe – if you wanted to escape the Horde you retreated behind big thick city walls, writes Dan Denning for the Daily Reckoning Australia.

But once the Europeans copied the Chinese and figured out just the right mix of saltpeter, sulfur, and charcoal, they began blowing each other's walls up. This eventually led to the emergence of the nation state as we know it in about 1688.

We take you on this one paragraph tour of 500 years of European history because it bears directly on the Dow Jones Industrials finally closing above the impressive 15,000 level. Woo hoo! A hand for the Dow, please.

Just as the defenseless poor of Europe fled behind the walls of the citadels, so too are investors today retreating into the only liquid and apparently safe stocks they can find. Today's investors aren't trying to escape the most lethal mounted warriors in the history of the world. They're escaping the most dangerous enemy of the modern world: deliberate central bank intervention in the value of everything. The chart below proves the point.

Source: StockCharts

You should know by now that the Dow is mostly a marketing tool used by Wall Street to promote the idea of stocks for the long run. As an index, it is almost entirely meaningless. It communicates almost no useful information. But in the never-ending search to reckon with the daily news flow, we believe we've squeezed out at least one useful insight from the mess of lines above: blue chip stocks denominated in US Dollars could go a lot higher.

Now hold on. Before you accuse us of making a laughably stupid statement, let us take you through the chart. The pink line shows the Dow is up 16.43% in the last year. That's pretty good for a 12-month period, although you can see almost all of that gain has come since November. That's an important detail, and we'll come back to it later.

The Dow is a price-weighted index. That's what makes it mostly useless. The more expensive a share is, the more weight it has in the index. In other words, the Dow values shares more because their price is higher. This would seem to violate the old axiom that price is what you pay and value is what you get.

But what have people been paying for? The chart shows the four Dow index members that currently have share prices in excess of $100. If our understanding is correct, these four stocks would exert the largest influence over the progress of the index. The four shares are 3M Corporation (NYSE:MMM), McDonald's Corporation (NYSE:MCD), Chevron Corporation (NYSE:CVX), and International Business Machines (NYSE:IBM).

In performance terms, IBM and McDonald's have been the laggards of the group over the last year. 3M and Chevron, meanwhile, have led the pack. To be honest, Chevron's performance is a bit baffling. In a slow-growth world with stable oil prices, you wouldn't make a big bet on a major oil company.

But oil companies are also like mini nation states. They operate globally. And there is always the possibility of another Middle East war. That would make a company like Chevron a kind of proxy for geopolitical instability. What about the rest?

3M is your quintessential conglomerate. When you look at its operating divisions, it's hard to find something the company does NOT produce. Operating segments include Industrials and Transportation, Health Care, Consumer and Office, Display and Graphics, Security and Protection Services, and Electronics and Communications.

It really is like a small economy, with employees as citizens and shares as currency. In our 'big picture' analysis, a conglomerate like 3M has a greater chance of survival in a deflationary depression than many modern nation states. That's not to say times won't be tough. But will 3M get by better than, say, Spain?

What's ominous for anyone who is already baffled by the Dow's rise is that tech stocks haven't really joined the party yet. The big gains on the S&P and the Dow have come from consumer staples, financials, and high-yield stocks. Now is the point where the rally could become self-fulfilling.

That is, because the Dow is a price weighted index, high prices tend to lead to higher prices. Prudent savers on the sidelines who look at the economy and realize growth sucks will find it hard to not jump into the rally. Cash from the sidelines will come in and the rally could broaden to include those blue chips that have missed out so far.

All of this is speculative tail chasing. But that's what you get when the value of the currency is systematically weakened by the saboteurs in central banks. And it makes a certain sense in terms of John Exter's liquidity pyramid. Capital flees from the risky assets at the peripheral of the financial system to less risky or more tangible assets at the core.

There is an aspect of pragmatism to this kind of speculation. You have to do something with your money in a low interest rate world. It looks like more and more investors are taking the path of least resistance and piling into blue chip stocks, perhaps at the expense of AAA rated government bonds (look out Australia).