On May 26, 1896, Charles Dow and Edward Jones took 12 companies that represented the largest in each sector of the United States stock market. The first published value of the Dow Jones was 40.94, which was calculated by taking the average market price for these 12 companies. With the exception of railroads and other modes of transportation, the original 12 companies represented every segment of the market at the time. As the economy changed over the years, the index changed along with it. In 1929, the index expanded to include 30 companies. Today, General Electric is the only company in existence in its original form, with the others having since been acquired, closed or merged with other companies.
The Dow is currently 18,473 – 450 times its original value in 1896.
Are people crazy to pay 450 times more in 2016? There are two questions to ask: how many new highs has the DJIA passed, and how can it keep going up?
Many reports tell us when the DJIA is making a new high, it will then go down. As they say, what goes up must come down.
Referenced from the CKW blog, CKW believes that both our lower for longer theme on fixed income early in the year (January) and our equities theme (April) are starting to play out. We believe longer-term investors will invest in rising earnings of their underling investments, rather than basing their decision solely on what the current price and potential price increases. If the DJIA and the S&P 500 both rise just over 35%, the DJIA will be over 25,000 and the S&P 500 over 3000.
Here’s how we can get there:
Case #1:
In this scenario (high growth, followed by low growth): The market is always fairly valued due to all known information being priced into the current value. A current year earnings estimate of $118 going to $134 in 2017 is approximately a 13.5% increase in earnings the following year. Then, if going forward in this unlikely scenario, earnings were to grow at a (bad) 2% rate for 9 years due to a lack of new inventions, things will be cheaper, better, or faster in the next 10 years. As you can see, 13.5% multiplied by 2% for 9 years gets us to S&P 3000.
Case #2:
In this scenario (no growth, reinvest all earnings and dividends 7+% growth annually): The consumer starts out confident. He realizes that the earnings yield on the S&P 500 is over 5% plus a dividend of 2%, and then compares this to his bank deposits or a 10-year treasury. After all, if the market just returned its earnings yield plus dividend, the S&P return would be equivalent to S&P at 3000 in 5 years.
Case #3:
In this scenario (E/P of market, reverts to norm vs 10 TSY): People come to realize the 10-year Treasury is correctly priced as the new normal and E/P (Earnings Yield of Market) spread reverts back to the norm. Let’s be a little cautious: 10-year TSY 2% and E/P of 2% calculates to a P/E of 50. Let’s cut it by 50% and say a P/E of 25. Earnings of $134 in 2017 times 25 = 3350. Maybe, 10-year US TSY is mispriced and should be closer to 5%. Then, according to historical norms, 17 times earnings would be reasonable.
Here we’ve presented at least three paths to a rising equity market. Ever since 1896, it appears to us that as long as earnings are rising, it is likely a safer time to make equity investments. So, if Q1 2016 represents a bottom for quarterly earnings, we can see a bounce from here.
The following is from FACTSET 7/22/2016:
“For Q2 2016, the blended earnings decline is -3.7%. If the index reports a decline in earnings. For Q2, it will mark the first time the index has recorded five consecutive quarters of year-over-year declines in earnings since Q3 2008 through Q3 2009.”
Well, maybe just like the market low in March of 2009, the market will bottom way before earnings do as investors compare earnings to the prior quarter, rather than the prior year. At CKW, we believe the market follows earnings over time. Currently, earnings seem to be rising versus last quarter, giving us confidence to overweight the equity allocation in the CKW Opportunistic Global Balanced model.
Much Aloha
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