I have no idea how high the stock market can go over the next year. I have the theory that stocks trade at fair value about once every three years. Having just come through one of the most destructive bear markets since the Great Depression, it is unlikely that the market will suddenly become efficient and sit on top of its statistical fair value in the coming year.
Having said that, our Dow Jones Fair Value Model is signaling that stocks have a long way to go just to reach their statistical fair value. The chart at the right shows the Dow Jones 30's actual price (red line) versus our Fair Value Model (blue bars) over the last 50 years.
A quick glance at the chart shows that the fit between the actual prices of the Dow and the Fair Value model has been reasonably good. The model, indeed, shows that stock prices were way too high relative to values in the late 1990s.
Currently, the model is saying that stocks are modestly undervalued, as shown by the price line being buried in the value bar at the far right. The top of the value bar, or the statistical Fair Value of the Dow Jones 30 is at 10,900.
If stocks were to reach our model's Fair Value over the next twelve months it would produce a return of over 18%. Thinking of gains when we just went through a 55% fall in prices is a difficult notion to grab on to. However, we believe the path of least resistance for stocks is now higher, and we believe our model's calculation of where stocks might be in a year is as good a guess as we can make.
The model is a multiple regression of trailing twelve-month Dow Jones 30 earnings, dividends, interest rates, and prices. It has an R2 in excess of .90 over the last 50 years.
Wednesday, August 05, 2009
The Fair Value of the Dow Jones Industrial Average
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2 comments:
There are many ways to get targets. I don't use the Dow anymore as I think they've done a poor job of maintaining its relevance. Using the S&P500 though, I am getting targets of 1200 with my technical methods. By no means is it as rigorous as your equation (impressive r2, btw), but it echos what you are finding...about 20% upside.
I respect what the market is telling me, but I am also one who thinks not many of the problems that we were knee deep in a year ago have been fixed. Things have a new coat of paint--a lot of govt money is out there, but I am not seeing from a fundamental standpoint improvement in financials. The cash for clunkers in the auto sector is targeted at an atypical car buyer. While there are fewer physical house for sale now than last year, demand has dropped faster--meaning the # of month's supply has actually increased. The amount of mortgage financing in the last 5months has decreased every month, while home sales have increased. This means the homes are going to flippers and/or people planning to rent them out, and do not need financing. So despite the $8k credit for 1st time homebuyers, most of the sales are not them or any "real" home buyer.
I really hope that both of our methods are correct and the market is 18-20% higher next year. But I really think this is one of the many times that the market is reflecting more hope than reality.
My discipline will have me invest, but I will have a hair trigger and not be surprised if it doesn't work.
Greg/Indy:
Sidestepping the valuation issue for a second, I would reiterate as I did on the other post to keep your eyes peeled on the Nasdaq as it churns under the resistance of the multi-year downtrend line. The Nasdaq has gone virtually nowhere despite the financials ripping and the REITS going absolutely parabolic.
That remains the telling sign in my view. Cisco may have put the nail in the coffin.
On the valuation front, I tend to look at the probabilities. From my credit perch, I see 3 likely scenarios:
1) a 20% chance we see a V-shaped recovery, assuming somehow the overleveraged consumer finds it in his heart to tack on more leverage and keep the economy afloat. This scenario warrants a 17x multiple on $80 earnings on the S&P.
2) a 50% chance we see a L-shaped environment where "flat" is the new "up". This scenario warrants a 14x multiple on $65 earnings on the S&P.
3) a 30% chance we see a deflationary collapse as the credit crisis which yielded the economic crisis paves the way for the biggest crisis of all - the funding crisis of the federal gov't. Unfortunately, the Chinese hinted at demanding floating rate funding via TIPS which could point to the initial rounds of Uncle Sam having his credit card declined. After all, there is only so much capital in the world (John Mauldin had a great piece on this). This scenario warrants a 12x multiple on $45 earnings on the S&P.
Put it all together... .20(17*80) + .5(14*65) + .3(12*45) = 889
Rounding up puts a fair value on the broader index at 900.
I think we can all agree we are in the grips of the bear for the next few years. Thus a proper investing strategy should include an active approach (buying in the 800's, selling in the 900's) and an income approach (Greg can attest many quality dividend players like MCD and MO are trading very cheaply right now).
I hope this note finds you well.
Dave G
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