Dow 11,000: Opportunity or Threat?

By Anand Chokkavelu, CFA 

October 11, 2010 

An admission: I'm a long-term buy and hold investor who knows better, but I still check my portfolio roughly 15.4 times a day. More often when the stock market's surging.

With the Dow at 11,000, Yahoo! Finance loves me. But as we all know (or should know), 11,000 is just a number. It should not spur any rash trading one way or the other.

To make the most of this arbitrary market event, I asked three of my fellow analysts for some advice for individual investors at these stock price levels.

Morgan Housel, Fool contributor: These milestones are generally meaningless, but I still think the market at these levels provides more opportunity than threat. The S&P 500 is on track to earn about $83 this year, and an estimated $94 next year. With the index at 1,165, I don't know where the overvaluation anxiety comes from. We're talking broad market multiples of 12-14, which should qualify as somewhere between cheap and reasonable -- with room for error. At the individual company level, high-quality companies like Microsoft (Nasdaq: MSFT)and Procter & Gamble (NYSE: PG) trade at valuations that shouldn't make sense to rational people.

My feeling is that the market's surge since the lows of March 2009 simply has many investors asking, "how is this increase justified?" They see a 70% market increase at a time when the economy looks like a cesspool, and it just feels wrong. But focusing only on the increase is misleading. The important question to ask is, "was the depth of the market crash justified to begin with?" I don't think it was. Look, corporate profits are at an all-time high. Nominal GDP is at an all-time high. Personal spending is at an all-time high. The long-term drivers of the stock market aren't doing as bad as some imagine.

Alex Dumortier, CFA, Fool contributor: Yes, last week the Dow crossed 11,000 for the first time since early May; however, it would be very difficult to argue that higher stock prices are now an opportunity for anyone who is a net buyer of stocks -- which I expect is almost everyone reading this.

Still, I will say that the blue-chip Dow index represents almost certainly a better opportunity than the broader market S&P 500, as the following table suggests:

Fund	P/E Multiple	Dividend Yield	3-5 Year EPS Growth
SPDR S&P 500 (NYSE: SPY)	13.8	1.89%	10.7%
SPDR DJIA ETF (NYSE: DIA)	13.2	2.69%	9.1%

Source: State Street Global Advisors website.

At a cheaper multiple, I'll take the extra 80 basis points in dividend yield of the Dow ETF over the 160 basis point advantage in estimated earnings growth for the S&P 500 ETF any day of the week -- something about birds, hands, and bushes.

Investors who have the time and the ability can earn yet better returns from stockpicking and, given the underpricing of high-quality companies, the Dow components make a good shortlist from which to begin one's search (legendary investor John Paulson likes and owns at least three).

Matt Koppenheffer, Fool contributor: I don't pay a whole lot of attention to the Dow. The index contains all of 30 stocks, and it's really tough to get a good feel for what's going on in the massive U.S. market based on that small number.

Past that, it's meaningless to focus in on a number like 10,000, 11,000, or even 111,000. It looks nice in newspaper headlines, but the price level of an index is only noteworthy when looked at in the context of the profits produced by the companies in the index.

When I focus in on something more meaningful -- like the S&P 500's current price-to-earnings ratio of 16.6 -- I'd say that it's hard to peg the overall market as being particularly cheap or expensive. But I consider myself a stock-picker and I'd say that there are certainly opportunities for investors to find great individual stock opportunities in this market.

The great thing is that a lot of the market's current opportunities are high-quality, dividend-paying, blue chips. Intel's (Nasdaq: INTC) stock, for example, is currently sitting at a forward P/E of just 10.6 and is paying a 3.2% dividend. Chevron (NYSE: CVX) has a forward P/E below 10 and a 3.4% dividend. It doesn't take a whole lot of brain busting to figure out that these are top-notch companies, so when I see these kinds of valuations, I'm all over them.

http://www.fool.com/investing/general/2010/10/11/dow-11000-opportunity-or-threat.aspx?source=irasitlnk0000001&lidx=5

Where do you think the market is headed?

What To Expect From The Market In The Next 8 Years

Mar. 10, 2010

(GuruFocus, March 9, 2010) This much we have a consensus: The current bull market was officially born on March 9, 2009 and market has rallied about 70% since then. What we do not know and we cannot agree on whether we are in a secular bull market or a bear market rally. 

That is the topic of debate between Robert Shiller of Yale University, Jeremy Siegel of University of Pennsylvania’s Wharton School, and Ben Inker of GMO LLC, as it is written up in today’s Wall Street Journal. Shiller and Siegel became friends since their student years in MIT in the 1970s, yet they disagree on which way the market is going.

Shiller, author of famous book Irrational Exuberance in which he warned of the tech bubble before it burst in 2000, is on the bearish side. His reasons, according to the WSJ:

• Despite the two bear markets, stock have spent almost all their time since 1991 priced above historic average. History suggests that when the stock prices are high, performance in ensuing years is disappointing.
• Shiller compiled market data back to 1881, measuring stock prices month by month relative to corporate profits, To avoid short-term profit distortions, he uses an average of profits over the previous 10 years. Over the long run, by his measure, stocks trade at an average of about 16 times annual corporate profits.
• Today the ratio is about 20. Historically, when stock market hit that number, the average return a decade after that is about -2%, adjusted for inflation
• Catalyst for the bearish scenario could be when the government takes away the support in the housing market. Housing market could be turning down after a brief recovery, which could contribute to a decline in U.S. stocks.

Siegel, also author of a well-read book called “Stocks for the Long Run” is on the bullish side. He contends that Shiller’s method of looking at earnings of the past 10 years doesn’t work well in the current environment due to the large write-offs of the financials in 2008. Instead, he prefers to use the forecasted earning:

• When economy came out of recession, the common P/E is 18.5.
• Currently the market is selling at about 14.5 times forecast 2010 profits, making it cheap in comparison to the past after-recession market.
• If the P/E expand to 18.5, S&P could rise to1400 this year, a 23% gain from today’s level.
• What’s more, ”We could easily see 10% to 12% stock returns with low inflation in future years”, Siegel predicts.

Ben Inker, in consistence of the firm’s stance on the matter, presented his arguments from a different angle – he uses historical profit margins to forecast future corporate profits. His reasoning:

• Internet and real estate bubbles pushed corporate profit margin to 7% above historical level of 6%. The higher margin was due to exceptional borrowing and investment by corporations and consumers.
• While the one percent seems to be small, it represents a 17% jump in profitability which is not sustainable.
• Use the historical 6% margin and applying it to an expected rise in corporate revenues as the economy recovers, he finds that the stocks today trade at almost 19 times expected profits, making them expensive.
• To be reasonably priced, he calculates the S&P 500 would have to fall 21% to about 900.

Of course, true value investors will consider guessing the short-term move of the market is a fool’s game. Whether the market will climb 20% or decline 20% next is really everybody’s guess. Guessing the long-term’s performance might be a fool’s game too, if it is up to guys like Warren Buffett, Bruce Berkowitz, and Donald Yacktman to say. For them, one ought to buy a good business on the assumption that no matter how the market will performance in the next couple of years, the business will do well so will the stock follow.

But at least one can answer question of long term expected investment return of the market with a bit more intelligence.

What to Expect in the Next 8 Years?

GuruFocus has developed a webpage dedicated to answer that question. The theory behind (it is actually explained on the webpage itself, I repeat here in case you do not want to click to another page) is that market return consists of three component: dividend yield, profit growth, and change in market valuation. Quoting from the page:

1. Business growth 

If we look at a particular business, the value of the business is determined by how much money this business can make. The growth in the value of the business comes from the growth of the earnings of the business growth. This growth in the business value is reflected as the price appreciation of the company stock if the market recognizes the value, which it does, eventually.

If we look at the overall economy, the growth in the value of the entire stock market comes from the growth of corporate earnings. As we discussed above, over long term, corporate earnings grow as fast as the economy itself.

2. Dividends

Dividend is an important portion of the investment return. Dividend comes from the cash earning of a business. Everything equal, higher dividend payout ratio, in principle, result in a lower growth rate. Therefore, if a company pays out dividend while with growing earnings, the dividend is an additional return for the shareholders besides the appreciation of the business value.

3. Change in the market valuation

Although the value of a business does not change overnight, stock price does. The market valuation is usually measured by the well-known ratios such as P/E, P/S, P/B etc. These ratios can be applied to individual business, as well as the overall market. The ratio Warren Buffett uses for market valuation, TMC/GNP, is equivalent to the P/S ratio of the economy.

Putting all the three factors together, the return of an investment can be estimated by the following formula:






Investment Return (%) = Dividend Yield (%)+ Business Growth (%)+ Change of Valuation (%)

Armed with this analysis and assuming in 8 years, the TMC/GDP ratio takes any one of the 40% (doom’s day scenario), 80% (average scenario), and 120% (happy ending), one can calculate the expected investment return.








As of now, we should expect an average gain of 5.7% for the next 8 years if the market ends the 8-year period at TMC/GDP=80%. Yes, it is mediocre gain as compared to the historical average gain, but it does beat the 10-year treasury yield by about 2%.

Market could sink an average of 2.6% per year if TMC/GD ratio declines to 40%, an extreme level seen in the 1975 to 1985 period. During that period, OPEC was on our case and inflation ran as high as 12%, and long term treasury bonds were yielding at a double digit. Will we go there?

However, if the market participants decides to irrationally exuberant again and TMC/GDP jumps to a 120%, level seen in the 1998-2000 period, we could actually expect a 11.6% gain per annum. What medicine do we need to take in order for us to be so happy again?

So even in long run anything is possible -- if the market goes to the extremes in the next 8 years, the bears like Shiller and Inker could be right, so could be the bullish Jeremy Siegel. Investors are better equipped to know what to expect under each scenario. GuruFocus memebers can access the Broad Market Valuation in real time.

"That's why the value of expertise and the ability to interpret information will someday go to infinity", so says Investment Guru Wilbur Ross recently. 

http://www.gurufocus.com/news.php?id=87078