The Dogs of the Dow: an investor's best friend

December brings many things to mind: Christmas, New Year, shopping and parties are the obvious ones. But as far as the financial markets are concerned, visions of sugar plums are replaced by end-of-year tax selling and stock market window dressing.

And while some people often consider the period to be quite uneventful, all you need do is take a look at what going on right now. The net result of the remarkable July-December rally is that all three major stock market indexes are currently trading at highs. The Dow hit a new record high of 12,486.30 today, with the S&P 500 following suit and setting a six-year high of 1,431.63. The Nasdaq Composite also bounced to a multiyear high of 2,470.02. Many of the smaller-cap indexes are also at new all-time highs. And all this despite a lack of truly explosive economic news.

What this does is present some pretty attractive possibilities for you - particularly with the Dow Industrials - because it puts additional pressure on stocks that have underperformed for the year and, in the process, creates some good buying opportunities in high quality stocks.

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There are many different ways that you can search for these artificially depressed stocks... but one tried-and-tested method is by buying the 'Dogs of the Dow.' So let's take a look at how this strategy works, and see how you can kick off 2007 in style by bagging some 'rebound profits.'

Dogs of the Dow: how this buying strategy works

While many investors have heard about the Dogs of the Dow theory before... some don't actually know how well this buying strategy has performed over the past 30 years. And this is the perfect time of year to familiarize yourself with the mechanics of this strategy and how it works.

It's really a very straightforward method. After the stock market closes on the last trading day of the year, you simply select the 10 stocks within the 30 that make up the Dow Jones Industrial Average that have the highest dividend yield (Dividend yield is the annual dividend payout of a stock divided by its share price). Then just call your broker, or go to your online account, and invest an equal dollar amount in each of these 10 high-yielding stocks. You should hold these 10 Dogs of the Dow for one year and repeat the process at the end of each year.

Dogs of the Dow: safe, and sound returns

So how has this Dogs of the Dow strategy performed over recent years?

According to an article in the July 1996 issue of U.S. News and World Report, employing this technique at the end of each year would have given you a 17.7% average annual return since 1973.

That's not bad considering the overall return of the Dow Jones Industrial Average during that same period was 11.9%.

Moreover, not only has investing in the Dogs of the Dow been historically more profitable than buying all 30 Dow stocks, it's also been safer. I'll give you a few examples...

During 1973-1974, the Dow Industrials lost 33%, while the Dogs of the Dow actually gained 2.6%.

1977 and 1981 were two more years in which the Dow Industrials lost ground, while the Dogs gained.

During the difficult bear market years of 2000-2002, the overall Dow Industrials shed more than 23% of its value. But had you followed the Dogs of the Dow strategy instead, your loss would have totaled less than 8%.

There have been some years when the Dogs have underperformed. But remember... this is a long-term strategy that should be implemented every year. And recent history has proved this:

During the tech bubble of the late 1990s, the high-dividend Dogs of the Dow stocks were up 28.6% in 1996... up 22.2% in 1997... up 10.7% in 1998... and up 4.0% in 1999.

During the brutal bear market at the turn of the century, the Dogs of the Dow were up 6.4% in 2000... down 4.9% in 2001... and down 8.9% in 2002. Losses, yes. But they were still much less than the overall Dow, S&P 500, and Nasdaq.

In 2003, the Dogs of the Dow gained 28.7% and made new, all-time highs - despite the fallout from the massive bear market of 2000-2002.

In 2004, the Dogs of the Dow notched up a 4.4% gain.

Dogs of the Dow: watch out for Congress

The fact is... the Dogs of the Dow have outperformed the Dow Industrials over the long-term. And although we don't yet know what the new Congress will do concerning current tax law, the favorable 15% tax on dividends enacted by the Bush administration is another powerful incentive to seek out stocks that pay generous dividends - and have the capacity to maintain their dividend payouts over time.

And to get the most from the strategy, it's important to employ it properly by holding all, or most, of the relevant stocks, because you never know which ones could be the big winners.

For example, 2005 was one of the few times that the broader Dow outperformed the Dogs - but that was mostly due to a 51% collapse in GM. But if you stayed patient and implemented the strategy again for 2006, you'd see that GM corrected and is the biggest winner this year.

Dogs of the Dow: try puppies instead

If you don't have the capital to invest in the 10 Dogs of the Dow, fear not. There is a similar strategy called 'Puppies of the Dow.'

The only difference between the two is that you take the ten highest-yielding Dogs of the Dow stocks - but instead of investing in them all, the Puppies of the Dow theory requires that you invest equal dollar amounts in just the five lowest priced stocks within the group.

According to the same U.S. News and World Report I referenced above, this strategy even outperformed the Dogs of the Dow, with an annual return of almost 21% between 1973 and 1996.

Dogs of the Dow: forget the 'January effect'

Around this time of year, you'll begin to hear more and more mentions of the 'January Effect.' Simply put, this phrase refers to an increase in share prices throughout January, as investors go on the hunt for bargains in the stocks that sold off at the end of December, due to investors creating a tax loss in order to offset any capital gains.

But, since most of Wall Street has become aware of this anomaly (and because many investors now trade with tax-protected retirement accounts), it seems to occur more so now in December than January. That's why implementing the Dogs of the Dow strategy 2-4 weeks before the end of the year may enhance your return even more.

Right now, I'm in the process of researching whether the Dogs or Puppies of the Dow would work even better during just the best six months of the year (November-April) and avoiding the worst 6 months (May-October). If the results are noteworthy, I'll update you in a future Smart Options message.

So this holiday season, you might want to think about adding the Dogs of the Dow or Puppies of the Dow to your investment strategy. The track record over the past 25 years or so speaks for itself, but do bear in mind that there have also been periods in which buying the Dogs of the Dow has under-performed the Dow as a whole. You should be aware that this is a long-term investment strategy and not expect the Dogs to outperform the broader Dow every year.