America’s flawed stockmarket indicator approaches a new milestone
By Buttonwood
SOME time soon, the Dow Jones Industrial Average seems likely to break through the 20,000 barrier, an event that will be greeted with banner headlines and a sign that capitalism is flourishing again. In fact, the Dow is a flawed measure, which uses the odd approach of weighting its component companies by share price. The biggest stock in the Dow is Goldman Sachs and despite its prominence on the campaign trail (and among Donald Trump’s new team), it is hardly the most important company in America; its weight depends on its near-$240 share price. Like other financial shares, it has shot up in the wake of Mr Trump’s election; boosted both by hopes of bank deregulation and of potentially higher interest rates, which tend to boost bank profits. William Wright of New Financial estimates that Goldman staff's wealth, in the form of options and shares, has risen by $2.3bn since the polls; not exactly a "revolt against the elite".
The Dow is up 9% since November 7th, well ahead of the more broadly-based S&P 500’s 6.6% gain. The S&P uses a weighting by market value—its biggest stock is Apple which, like many other tech stocks, has seen far less of a boost from Mr Trump’s election. Apple only has the 11th biggest weight in the Dow.
Still, the American stockmarket rally since the election has been quite remarkable, given the qualms expressed by many investors before the election. The big hope is that Mr Trump will focus on his plans for fiscal stimulus and corporate tax-cutting; this will boost America’s economy and corporate profits. But it may also push up inflation so investors are switching out of Treasury bonds and into equities. At the same time, investors are counting on Mr Trump to forget about, or downplay, his protectionist rhetoric; as yet, they have been remarkably sanguine about his twitter wars with China.
In the past, the markets have sometimes taken a pause for breath after reaching Dow milestones (see chart). The average first reached 1,000 during the trading day in 1966 but did not close above that level until 1972; it then fell sharply and only reclaimed the 1,000 level 10 years later. The 10,000 market was reached during the 1990s tech boom. Although the average reached 11,000 in 1999, it suffered two big setbacks over the following decade, falling to 6,600 in March 2009. But by November that year, the average was back over 10,000 again and the records have kept coming; 15,000 was reached in May 2013, and 19,000 as recently as November 22 this year. (The authors who predicted, in separate books, that the Dow could reach 36,000 or even 100,000 have yet to be vindicated.)
Any investor buying into the market at the current level needs to be aware that a fair degree of good news is in the price. The S&P 500 is trading on an historic price-earnings ratio, relative to last year’s profits, of 21; it has spent the vast bulk of the last 90 years trading below that level. Use the average profits over the last 10 years, a method popularised by Robert Shiller of Yale, and the ratio is 28.3, nearly 70% above the long-term average. Relative to book or asset value, share prices trade on a ratio of 3, a more modest 25% above the long-run average. The dividend yield of 2% is well below the historic average; on the other had, investors may feel this is perfectly respectable relative to the tiny yield on cash and the 2.44% available on 10-year Treasury bonds; after all, they can hope for dividend growth and share buy-backs especially if companies repatriate their overseas earnings.
The biggest threat to equities comes from two directions. The first is the Federal Reserve, it is expected to raise rates later today although, as a result of those expectations, that news must already be reflected in share prices. But if the Fed indicates a sustained period of rate increases, the markets may take fright. And the second risk is that Mr Trump’s stimulus falls short; it gets diluted in Congress or fails to have the anticipated effect (after all, the Japanese have been trying, and failing, to stimulate their economy for decades). Oddly enough, given the perceived pro-business policies of Republicans, the American market has performed much better under Democrat presidents.
