Yesterday the Dow Jones Industrial Average climbed above 10,000, restoring the U.S. stock market to pre-crisis levels, with great fanfare from the media. But does the number really mean anything? Unless the Dow at 10,000 coincides with some extreme in valuation -- and if the 3Q 2009 earnings reports are a reliable indicator of what we'll see in the near term, it doesn't appear to be -- it's not a "destination" for the market. Rather, it's just a number, like one of those small, frequent mile markers that tick by on the interstate. That's what I expect, and it's also what MSNBC viewers heard this morning (October 15th) from Maria Bartiromo.
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 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. (The average since 2004 has been lower -- about 0.8.) If that's the case, today's reading, at 0.6, is still below average.
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.
The earnings we're seeing for 3Q 2009 tell us that some areas and companies are improving, while others are still stuck. For instance, JPMorgan Chase had a good quarter, but we're not out of the woods. Demand for business and consumer loans is still weak, and home mortgage foreclosures remain stubbornly high. Goldman Sachs's 3Q earnings were very strong, from its trading operations. On the other hand, Nokia has just reported an awful quarter, reflecting poor sales and an asset writedown in its network operation.
These round numbers on the Dow can be sticking points for the market machine. 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.