By Greg Donaldson and Mike Hull
By our reckoning the stock market, as measured by the Dow Jones Industrials, is significantly undervalued, maybe as much as much as 13-15%. We make this call based on the readings of our Dividend Valuation Model using the most recent data available.
By our reckoning the stock market, as measured by the Dow Jones Industrials, is significantly undervalued, maybe as much as much as 13-15%. We make this call based on the readings of our Dividend Valuation Model using the most recent data available.
The chart at the right shows the model going back to 1975. The blue line is the average annual price of the Dow and the green bars are the model's predicted values. The model uses only the dividends paid by the 30 companies in the Dow and long-term high-quality bonds. We have previously explained that we believe the model has done a good job of indicating when the market was cheap and when it was dear.
Until the early 1980s the model indicated that values remained flat. This was a period when interest rates were shooting higher, and their ascent overwhelmed the modest dividend growth during the period.
During the mid to late 1980s and early 1990s the model said the market was undervalued, which turned out to be correct. Prices and values came into equilibrium in 1994 and 95, before prices went off into their tech fit -- and the model refused to go along.
Since the end of 2002, the model has signaled that the market has been undervalued.
The model's exact reading as of today is 13,980. That is based on dividends paid thus far in 2007 by Dow companies and interest rates at their current level. But this coincident pricing is not the way that the stock market operates.
During normal times, the market discounts what it can see, which is normally a year or so ahead. If we add in our projections of dividends and interest rates for he next 12 months, we arrive at a total return for he Dow of just over 14%. This would include the catching up of the current undervaluation and then achieving a fair value on next year's growth.
We think this is very possible if the Fed begins to cut rates. Importantly, we believe that kind of rate of return will come sooner rather than later, once the Fed makes it first rate cut. Think of it as being front loaded.
Our best guess is that the current gyrations in the stock market and headlines of this doom or that will provide cover for a new leg of the bull market that began in 2003 to begin.
We cannot see the future better than anyone else, but we are students of the past and that is how markets usually react, once a crisis is beginning to wane.
