Tuesday, January 25, 2011

Dow 12,000 – Who’d a Thunk It?

From the Desk of Joe Rollins

Last night’s financial news programs were focused on the Dow Industrial Average approaching 12,000. I’m not exactly sure whether the commentators were outraged, alarmed or indifferent regarding this prospect, but I certainly am not surprised that the Dow is moving higher.

In March of 2009, the Dow had dropped to 6,440. It appears that before the end of this month, the Dow will have almost doubled in the intervening 22 months. It’s unfortunate to see so many investors sitting on the sidelines watching the stock market double without jumping into the game, and it is equally frustrating advising investors to at least make their IRA contributions early in the year only for so many to never do so. Their answer is always “Soon.”

A client recently asked me when I thought the Dow would reach a new all-time high. While anyone can guesstimate when that might happen, performing a calculation based on the current data provides a more likely scenario. So many commentators in the financial press make outrageous predictions, but very few of them actually perform calculations based on economic data to determine the possibilities. The following is a good exercise in how to perform this calculation.

It’s easier to obtain information on the S&P 500 than the Dow Industrial Average. The S&P is also a better indicator since it includes 500 companies as compared to the Dow’s 30. Using the S&P’s information, I performed a calculation and extrapolated the outcome to include the Dow Industrial Average.

As I have written so many times in previous posts, the most important component to pricing stocks is earnings. The higher the earnings, the higher the potential stock prices. Of course interest rates play a part; the higher interest rates are, then the more likely that interest-bearing certificates would be competition for the stock market and would draw money away from stocks into fixed rate investments. However, we currently have the best combination for investing possible: extraordinarily low interest rates with CDs and government bonds paying very low rates, along with very high corporate earnings. This is the optimal time to be investing in stocks.

For 2011, most projections reflect that the S&P will return earnings of approximately $90 per share. If you use the standard, blended-rate multiple of 15.7, you get an index value at the end of 2011 of 1,413. It’s easy to pick a price/earnings ratio that would be highly volatile. As you are likely aware, the ratio is simply the average price of all the stocks in the S&P 500 divided by the average earnings of those same stocks. In other words, how many times earnings would the price be? P/E ratios historically go from a low of 14 to a high of 20, and the S&P 500 uses a conservative blended rate of 15.7.

Based on earnings of $90 earnings and a 15.7 multiple, the S&P would gain 9.7% for the year 2011 and end the year at 1,413. Given that interest rates are earning almost zero and a 10-year Treasury is earning 3.4%, a return of 9.7% would be spectacular performance for the year. The S&P earned 26.46% in 2009, 15.06% in 2010, and could potentially earn 9.7% in 2011, an extraordinary run of excellent performance.

For 2012, the so-called experts are forecasting earnings of roughly $100 for the S&P 500 companies. At a 15.7 multiple, the percentage increase for 2012 would be 11.1%. Therefore, if these numbers actually come to fruition, then the S&P 500 would have an annualized return from 2009 through 2012 of 15.39%. Given that inflation has been at virtually zero during this timeframe, then that return may very well be the highest rate of return in respect to inflation ever.

Extrapolating the same increases in values for the Dow Industrial Average at 12,000 now provides the following:

S&P 500
January 25, 2011

December 31, 2011 - 9.7% gain
December 31, 2012 - 11.1% gain

The recorded all-time high closing for the DJIA occurred on October 9, 2007 at 14,165. Based upon my calculations above and good historic data, it appears that the next all-time high for the Dow that surpasses the high recorded in October of 2007 will occur in 2012. Obviously, investing is not as simple as forecasting, but given the current extraordinarily high earnings of the U.S. corporations, this should happen sometime next year should my forecast prove correct.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

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