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Stocks Take Another Blow From Fed Fears

As was the case in June, traders sold off equity holdings again in August, as bond yields headed higher. And, again, the catalyst was increasing concern that the Fed would begin winding down its popular bond-buying program as early as September. (The Federal Reserve’s purchases help support stock prices by keeping bond yields low, and thus making fixed-income investments a less-attractive alternative to equities.)

August turned out to be the worst month of the year so far for equities, and an equally weighted position in all 30-Dow components would have resulted in a 4.4% decline in value. The Dogs of the Dow (the 10 Dow stocks that started the year with the highest yields) fared only slightly worse, shedding 4.9% for August.

None of the Dogs escaped unscathed, although Merck(MRK - Free Merck Stock Report) and DuPont (DD - Free DuPont Stock Report) came closest, with relatively modest declines of 1.8% and 1.9%, respectively. As it turns out though, the biggest punishment was meted out to the two pups that had had the strongest year-to-date showing up through July. Computer maker Hewlett-Packard (HPQ - Free Hewlett-Packard Stock Report) was hit hard with a 9.1% decline, while shares of Johnson & Johnson (JNJ - Free Johnson & Johnson Stock Report) got a 7.6% crew cut.

However, Year-To-Date Performance Remains Admirable

Thanks to the gains recorded in all seven months prior to the August dip, the Dogs held on to a double-digit advance for the year so far, which compares very favorably to their historical performance. Moreover, the Dogs’ running tally has maintained a lead over the Dow 30 Industrials and the 20 “non-Dog” Dow components throughout the entire year. At the end of August, the Dogs were up 17.5% for the year to date, compared to 15.4% for an equally weighted position in all Dow stocks and 14.4% for a similar position in the 20 other Dow issues.

It’s not surprising that computer giant Hewlett-Packard still leads the pack. Even with the aforementioned stumble last month, its stock was up 63.8% through August. The company’s July quarter results came in better than expected, thanks to lower-than-anticipated restructuring and acquisition costs. Management raised its full-year fiscal 2013 (ends October 31st) earnings forecast, from $2.50-$2.60 per share to $2.67-$2.71 a share. Overall, although the company is making slow progress, it’s still in the early stages of what will likely be a multi-year recovery process. As for the pullback in August, it’s likely that a shaky market prompted some nervous investors to lock in some of the year’s healthy gains in the stock.

Shares of diversified chemicals manufacturer DuPont have also turned in a noteworthy performance, rising 25.9% for the eight months through August. It appears that traders were encouraged by second-quarter earnings that slightly exceeded the consensus expectations and the news that the company is exploring strategic options for its troubled Performance Chemicals segment. We estimate the company’s earnings will be up 10%-15% for the year.

Coming in third on the list of top advancers is Johnson & Johnson. Although, as noted above, the stock faltered in August, it retained a 23.3% gain for the year to date. The company reported favorable June-period results, with sales up 9% from a year earlier while adjusted share earnings soared 14%. However, management was hesitant to raise full-year earnings guidance by a considerable margin after the strong showing, and it appears traders decided to take some profits off the table as equities pulled back.

A Rare Shake-Up in the Make-Up of the Dow Industrials

In the most ambitious change in the composition of the Dow 30 Industrials in nearly a decade, it was recently announced that aluminum manufacturer Alcoa (AA - Free Alcoa Stock Report), top-Dog Hewlett-Packard, and Bank of America (BAC - Free Bank of America Stock Report), the second-largest financial institution in the U.S., will soon be dropped from the widely-watched blue chip index.

Alcoa, which held its spot for 54 years, will be replaced by Nike (NKE), the maker of athletic gear. Hewlett-Packard, which has been a member of the Dow for about 16 years, will be flipped in favor of electronic payment behemoth Visa (V). Lastly, junior member Bank of America will be replaced with the venerable securities firm Goldman Sachs Group (GS) These moves, scheduled to take place at the end of trading September 20th, represent the biggest revamping of the Dow since 2004. Reasons cited for the change included the relatively low prices and weak performance of the exiting stocks in recent years, as well improved Index diversification.

How will this affect the Dogs? In order to hold true to the original spirit of the strategy, we will assume no changes in the makeup of the Dogs portfolio. That is to say, HPQ will stay for the duration of the year.

Meanwhile, to maintain real-world performance comparisons for the Dow as a whole (and for the subset of 20 non-Dog stocks), we will we will track the Dow 30 stocks’ performance with the new components from September 23rd onward, while year-to-date returns will incorporate the tallies recorded by the original members through September 20th.

Conclusion

Despite the recent turbulence in the markets due to participants second-guessing the Federal Reserve’s next moves, stocks, and the Dogs of the Dow in particular, have posted historically strong returns this year. Meanwhile, economic conditions suggest the backdrop should be benign enough for the Dogs to hold on to the majority of their gains in the closing months of the year, with a measure of support provided by the group’s above-market yields.

At the time of this article’s writing, the author did not hold positions in any of the companies mentioned.