As the Dow Breaks 9,000, What's Next?

Optimism's back! Emboldened by stronger-than-expected earnings from eBay (Nasdaq: EBAY  ) and Dow component AT&T (NYSE: T  ) , investors pushed the Dow Jones Industrial Average (DJIA) above 9,000 today for the first time since January. This milestone caps a good run for the index recently, which is up approximately 7.5% since the end of June.

Here are the five Dow components that have posted the highest returns since the end of June:

Company

% Return Since June 30

2010 Est. Price-to-Earnings Ratio

American Express (NYSE: AXP  )

24%

20.1

Caterpillar (NYSE: CAT  )

17%

23.3

Intel (Nasdaq: INTC  )

16%

17.4

Cisco Systems (Nasdaq: CSCO  )

15%

15.4

DuPont (NYSE: DD  )

11%

14.0

Source: Author's calculations based on data from Capital IQ, a division of Standard & Poor's.

Will this strength continue? The only way I know to approach that question is by looking at valuations, so here's where we stand (based on yesterday's closing prices):

DJIA

8,881.26

P/E (2009 est. earnings)

14.0

P/E (2010 est. earnings)

11.9

Cyclically-Adjusted P/E (average inflation-adjusted earnings over the past 10 years)

10.2

Source: Author's calculations based on data from Capital IQ and Dow Jones.

Neither cheap, nor really expensive
Considering that the Dow contains some of the largest, most mature companies in the U.S., 14 times this year's earnings doesn't appear to be any great bargain (though it doesn't look wildly overpriced, either). Of course, that highlights one of the DJIA's fundamental shortcomings: It lacks breadth. Thirty stocks aren't a great proxy for the entire U.S. stock market. For a more accurate picture, I prefer to look at the S&P 500 instead.

At yesterday's closing price of 954.07, the broader index is valued at 16.5 times its average inflation-adjusted earnings over the last ten years. Comparing that multiple to its long-term average (going back to 1881!) of 16.3 confirms the idea that stocks aren't particularly cheap right now. Investors buying at these levels shouldn't expect to do any better than the average historical return for stocks (especially if one factors in the prospect of future earnings growth that is below the historical trend).

What sort of returns should we expect?
Speaking of which, the folks at respected asset manager GMO -- which called the Internet and credit bubbles -- recently released their latest asset return forecasts. As of the end of June, they believe the annualized returns for large-cap and small-cap U.S. stocks over the next seven years will be approximately two percentage points lower than the long-term historical U.S. equity return of 6.5% (excluding inflation).

Stock investors shouldn't extrapolate the stock market's recent strength. While it's impossible to make six-month forecasts with any certainty, if stock valuations are any indicator, returns will be more muted during the second half of the year.

Large-caps might not offer great returns, but GMO is forecasting that "high-quality" U.S. stocks will beat large-cap stocks by more than six percentage points annually over the next seven years! Morgan Housel has identified three high-quality companies that are still cheap.

More Foolishness:

Take a hint from Warren Buffett's recent investment in preferred shares with fat yields: In this market, dividends will be a big part of future returns. The team at Motley Fool Income Investor can show you how to build -- and manage -- a portfolio of stocks that pay a growing dividend. To find out their top five recommendations for new money now, take advantage of a 30-day free trial today.

Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. eBay is a Motley Fool Stock Advisor pick. American Express, eBay, and Intel are Motley Fool Inside Value recommendations. The Fool owns shares of Intel and American Express. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.


Read/Post Comments (12) | Recommend This Article (40)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 23, 2009, at 4:27 PM, masterN17 wrote:

    Profits are rising because jobs are being slashed. The growth is not sustainable but that doesn't imply a corrective drop is coming. It may either level off or fall some. Be prudent with new investments.

  • Report this Comment On July 23, 2009, at 8:06 PM, Scaooba wrote:

    I feel the same way also. Recently bought some KMB but still had some more to buy and thought should wait. Because I still feel this isn't sustainable either, for the same reasons.

    Still, seeing the DOW and all my stocks climbing like this makes me think I should buy some now while they are still better bargins. But have to keep a cool head about yourself and not buy into the market mania.

    Just heard in the news on the way in to work that more people filed for unemployment than the week before. Went to a subway for lunch in a little strip mall that had every store around it filled. Today though the subway was the only thing there. Everyone else had closed up shop.

  • Report this Comment On July 24, 2009, at 9:37 AM, VegasMartin wrote:

    This is pure bottom line growth only. Revenues are shrinking and cost cutting will only get stocks so far. Eventually stocks will need revenue growth to grow and that has a while before it happens. It's nice that EPS beat estimates and that helped stocks rebound to their November levels, but I don't see them breaking through to 10,000 any time soon. There should be a pull back to 8,600-8,700 before it moves higher. The market is overbought based on hope. After a pull back, it should rise again to 9,500 by January. Q3 will again be pivitol before you see more people coming in off the sides and again, there will be winners and losers.

    www.ShootTheBears.com

  • Report this Comment On July 24, 2009, at 10:22 AM, ChannelDunlap wrote:

    I went to TMF homepage, where I followed a link to TMF Twitter, where I followed a link.. BACK TO THE HOMEPAGE. Now that efficiency.

  • Report this Comment On July 24, 2009, at 11:36 AM, plange01 wrote:

    the car rental stocks (dtg) and (car) are still on fire! these stocks are just into their best season and have a lot of upside left..watch out for hedge(trash fund) controled..(htz) to much debt!

  • Report this Comment On July 24, 2009, at 12:19 PM, hutkoff wrote:

    How high must the dow climb before baby boomers start to retire en mass? To clarify, what is "good enough" to recapture lost value from the historic highs where it pays to cash in those assets?

  • Report this Comment On July 24, 2009, at 1:32 PM, shinybagel wrote:

    I'm not cashing in my assets when I retire. I plan on using dividend income. So long as dividends aren't cut or suspended, I don't much care what the market does. I'll not be waiting "to recapture lost value" or for prices that are "good enough".

  • Report this Comment On July 24, 2009, at 2:19 PM, vegasbob222 wrote:

    If you like dividends for income, and don't have real worry over downside movement in underlying stock, then sell covered calls or puts about 10% out of the money for the next month, on generally blue chip stocks and you can easily earn between 12 and 20% annually, including your dividend. If the stock appreciates beyond the call/put strike price, you give up some gain, but you can rebuy that stock or another and go again.

    There are tax implications because the call/put premiums are ordinary income, but you could easily double or triple your net current dividend yield.

  • Report this Comment On July 24, 2009, at 2:35 PM, YouHeardItFirst wrote:

    I do not believe for a second that the strength of our economy is reflected by the stock market today. If it made any sense, we wouldn't be seeing a rise in it now. I think it especially holds true after all this talk about more stimulus being needed and more losses projected for the government's current "investments". I heard a hearing this morning that quotes ungodly losses that the average tax payer is supposed to absorb. The attitude that everything is better now is absurd.

    I have some stocks I bought at extremely cheap prices with a great deal of baked in value with regard to their assets. I'm sticking with them and that's all there is to it. If I find something else I think is an extremely good deal, I'll go with it, but that is all I'm doing. This rise is a parlor trick, caused by some very greedy and stupid people.

  • Report this Comment On July 24, 2009, at 6:16 PM, drborst wrote:

    YouHeardItFirst,

    I don't think the stock market ever reflects the strength of the economy. It reflects the feeeling of a lot of investors about the future strength.

    But now that everyone has stopped talking about a W shape recession, I suspect VegasMartin might be right and we're closing in on a second drop.

    I'm building up cash so I'll be ready to buy when the prices get cheap again. I just wish these cycles would go slower, I hate selling when the income is ordinary and not capital gains...

  • Report this Comment On July 25, 2009, at 9:29 AM, Gregeph wrote:

    I agree that stocks do not look particularly undervalued here. One broad concern is that if we look at the market's P/E ratio using the average earnings of the past 10 years, the S&P's P/E ratio is 16.24. Also, even at the March, 2009 low it did not go under 10, which has happened in past bear markets. I also like to look at how the S&P's earnings compare to those of the 10 year U.S. treasury. Because interest rates are so low now, stocks are relatively more attractive. I lay out the data in my blog: http://valueinvestingfundamentals.blogspot.com/2009/07/are-u...

  • Report this Comment On July 27, 2009, at 1:53 PM, Classof1964 wrote:

    What many folks forget is that since 1800 we have regularly had bull markets followed by bear markets followed by bull markets. Seven times. It is not surprising that after the long bull market beginning in 1982 (or 1975-2000 according to some analysts), that we are in for a bear market. In such markets there can be rallies for a while, but because bull markets have a tendency for excess (excess capacity, excess borrowing, extended, excessive P/Es, etc.) at some point the bubble bursts. And it takes years (8-15) for the basis of a new bull market while the economy adjusts. There is far too much short term thinking in finance and investment these days.

    This is a very good article, but it could have taken a longer term analysis than ten years. Ten years leaves us back in the waning years of the greatest bull market in US history. One wonders if it will be followed by one of the greatest bear markets in US history. Probably not the greatest because of the role of the Fed and the Federal Government these days.

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