Smart Investing

 

February 24, 2012

October 25, 2013


Watching the Dow climb

On Thursday morning, I did a commentary on News 8 about the Dow Jones Industrial Average reaching 13,000, the economy and gas prices.

That's a lot to fit into a three- to four-minute segment, but I tried my best to answer the anchor's questions and back up my answers. There is so much data that I’m reading that backs up my optimism, I’m not sure I can even fit it all in this column.

I know some are thinking the Dow at 13,000 is high and may be the top. On my segment and my radio show, I'm now talking about the Dow reaching 15,000 to 17,000. Those who have followed me for years may remember back in 2007, when the Dow first crossed the 13,000 level, I was not that optimistic. Actually, I was more pessimistic.

So what has changed from five years ago?

Earnings per share have increased for many companies, for one. If you look at the second quarter of 2007, the S&P 500 EPS was $24.06, an all-time quarterly high. Compare that to the fourth quarter of 2011 and you will see an all-time quarterly high of $25.29. So yes, the S&P 500 is increasing in value, but so are the earnings.

How do we get to a Dow Jones high of 15,000 or 17,000?

Professor Jeremy Siegel, whom I’ve quoted in my column before, does a great job of researching history. His data goes back 141 years, further than anyone I know. As I have said many times, earnings are what drive the market higher. I know you might wish that would be a straight-up increase, but it is a jagged climb of ups and downs. Yet the peaks continue to climb over time as earnings improve.

While a Dow Jones level of 15,000 seems like a pie in the sky, and 17,000 sounds like I’m smoking something, let me put it into perspective for you. With a current PE on the Dow around 13.1, an increase in the PE to 13.6 (this includes a 6 percent growth rate in EPS) is not that much of an increase and is well-justified. This would bring us to 15,000. What has happened is earnings grew at a double-digit rate in 2011, and the market remained flat. If earnings grow as expected (consensus estimate of 9 percent), a Dow 15,000 would trade at a PE multiple of around 12.8, not very high at all.

To get to 17,000 from 13,000 in two years — a 31 percent gain — earnings per share need to grow at only a modest 6 percent per year. Using a slightly higher multiple on earnings per share of 15.4, the Dow would be at 17,000. Siegel also points out that in 2007 dollars, 17,000 would only be 7 percent higher, and this is with far better earnings.

I also like Siegel’s research on the reversion to the mean, which I also learned from famed investor David Dreman. Because the past five- and 10-year returns have been so bad, they're not just below average, but in the lowest quartile.

This acts like a rubber band: If you pull it down, it will rebound not just back to the middle, but above the middle, which is when the indexes could be overvalued. And at this time, investors should be watching their companies for high valuations and perhaps selling some of their holdings.

A gentleman by the name of Jeremy Schwartz also did some research on the worst performing quartiles among five-year periods and what happened the following two years. There were 33 five-year periods in the lowest quartile, and the median annual returns were 20 percent, about a 44 percent increase over two years. If that were to happen, the Dow would hit 18,720.

The reason why the average investor can’t make money in the market is that he doesn’t look at things like earnings per share growth or reversions back to the mean. They continue to have a mental block on the Dow and the S&P 500 at certain levels and think that is the top. They also worry about things that could happen, like rising gas prices or conflicts around the world. While these can have a short-term effect on the market, many businesses will still find ways to make a profit, and consumers will still spend their dollars somewhere.





Wilsey is president of Wilsey Asset Management and can be heard every Saturday at 8 a.m. on KFMB AM760. Information is provided by Reuters.


 

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