Dow 10,000: A Milepost, or the End of the Line?

Last Updated Oct 15, 2009 9:31 AM EDT

Update: The real economy has changed little since I made this two weeks ago, so I figure the logic still holds. And perhaps more important, this morning on MSNBC, Maria Bartiromo made the same point -- 10,000 is just a number.

The Dow at 10,000. Does it mean anything? It may be just fodder for financial writers: a Google search that also specifies September 2009 returns five million results. But it could be that the Dow Jones Industrial Average at 10,000 coincides with some extreme in valuation, and is a "destination" for the market. Otherwise, it's just a number, like one of those small, frequent mile markers that tick by on the interstate.

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During the years after the 2001 recession, investors reduced their expectations of the US economy's growth potential and the valuation of stocks. The graph below plots the Dow 30 (the green line), as well as the level of the Dow relative to current-dollar GDP (the blue dots), from before the tech bubble through the mild recession that followed, the credit bubble, and our current recession. (The red dots mark the beginning and end of recessions.)

The ratio of the Dow to GDP reflects investors' optimism and pessimism -- what price, in terms of Dow points, stock investors are willing to pay for a billion dollars of U.S. GDP. A higher ratio sets a greater value on current and near-term earnings, and presumably the longer term as well. Over the period the Dow/GDP ratio has ranged from about 0.5 to about 1.2, peaking during the tech bubble. It has averaged about 0.9 since 1995, and stands today at the low level, relative to its own history, of 0.6.

This analysis is back-of-the-envelope, and has several shortcomings. To mention two: the Dow is built from just 30 stocks, so it does not represent the entire U.S. economy, and although it is meant to portray the flower of American industry, many stocks are kept in the Dow index well past their prime.

It's tempting nevertheless to conclude that over the 15 or so years presented, the 0.9 average of the statistic is somehow normal, and today's valuation is below average. (The average since 2004 has been lower -- about 0.8.)

Let's look at the question another way: when the Dow first hit 10,000 in early 1999, the value of U.S. GDP was about $9.3 trillion in current dollars. When it broke through 10,000 again in late 2003, GDP had risen to $11.5 trillion.

Today, on the verge of Dow 10,000 once again, nominal GDP is over $14 trillion. If the Dow-to-GDP ratio holds, the difference between today's reading and the average suggest that today's GDP could support a valuation as much as 30 percent higher, given a boost in investor optimism. To me, 10,000 looks more like a floor than a ceiling.

But history reminds us that the market machinery does not run smoothly when it encounters these round numbers. In the September 28 Times, Jack Healy relates that the Dow was stuck under 1,000 for 15 years before its 1982 breakout. It also bounced around the 100 level in the turbulent time from 1906 all the way up to World War II. Healy concludes:

The New York Times ran a front-page article about the Dow's first trip across the 10,000 marker in 1999. This article is being written in September 2009. Investors should hope there will not be a similar article in 2019.