Wednesday, August 05, 2009

The Fair Value of the Dow Jones Industrial Average

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.