Has the Dow Topped?

In Pamplona, the annual running of the bulls ends in mid-July. On Wall Street, the event has taken on a life of its own this year, taking us through July and into August. On July 23, I wrote about the Dow Jones Industrial Average (DJIA) breaching 9,000, and only last Friday, the index hit a high for the year at 9,370.07. However, the rally appears to have run out of steam this week. Did the Dow hit a top?

 

Q3 Return to Aug. 7, 2009

Cyclically Adjusted P/E

Bank of America (NYSE: BAC  )

26%

5.7

General Electric (NYSE: GE  )

24%

6.6

Cisco Systems (Nasdaq: CSCO  )

16%

15.7

Intel (Nasdaq: INTC  )

13%

16.7

Pfizer (NYSE: PFE  )

6%

8.7

Wal-Mart (NYSE: WMT  )

3%

14.1

Procter & Gamble (NYSE: PG  )

2%

13.4

Source: author's calculations based on data from Capital IQ, a division of Standard & Poor's. P/E = price-to-earnings ratio.

Let me be quite clear: I can't predict whether Friday's high is a top -- only fools (small "f") and stock shills can do that. However, I can offer some thoughts on whether the Dow is reasonably priced at current levels.

Value matters
One of the most reliable indicators of value is the cyclically adjusted price-to-earnings (CAPE) ratio, which compares price to the average inflation-adjusted earnings over the prior 10 years. Designed to smooth out the effects of the business cycle, the CAPE was originally devised to analyze individual stocks by Benjamin Graham, the father of value investing. More recently, economists Andrew Smithers and Robert Shiller have popularized the use of the CAPE for valuing the U.S. stock market.

Following this methodology, I derived a CAPE data series for the Dow going back to 1940. The following table summarizes some of the results:

Dow Comparisons

 

DJIA (at Aug. 10, 2009)

9,337.95

Cyclically Adjusted P/E multiple

18.1

Average CAPE (full series: Jan. 1940 – present)

17.7

Average CAPE (April1975 - present)

19.3

Average CAPE (Dec. 1982 - present)

22.5

Source: author's calculations based on data from Dow Jones Indexes and Capital IQ, a division of Standard & Poor's.

Based on comparison of the DJIA's current multiple with the CAPE's long-term average going back to 1940, we would have to conclude that the index is about fairly valued. However, I also calculated the average starting at the month that followed the trough of the two longest historical recessions in the postwar era. By those yardsticks, the Dow remains undervalued at present (the same observation is true for the broader S&P 500 index).

Blue chips and the broader market
I could be persuaded to believe that the Dow is undervalued, which would be consistent with value maven Jeremy Grantham's assertion in his most recent quarterly letter that "the easy winner of the cheapest equity sub-category contest is still high quality U.S. blue chips."

On the broader stock market, I'm much more skeptical. My sense is that the S&P 500 is now overvalued. Investors should consider adjusting their exposure to U.S. equities accordingly and look beyond U.S. borders to international stocks.

Jeremy Grantham's firm, 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! Fool contributor Morgan Housel has identified three high-quality companies that are still cheap.

Quality matters. The team at Motley Fool Inside Value can show you how to build -- and manage -- a portfolio of high-quality-company stocks trading at reasonable prices. To find out its top five recommendations for new money now, take advantage of a 30-day free trial today.

Intel, Pfizer, and Wal-Mart are Inside Value selections. Procter & Gamble is an Income Investor pick. The Fool owns shares of Procter & Gamble.

Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. The Motley Fool has a disclosure policy.


Read/Post Comments (24) | Recommend This Article (66)

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 August 11, 2009, at 5:09 PM, gary923 wrote:

    Why sweat the DJIA... DJIA stocks has been reshuffled so may times most people could not tell what stocks are in it. Maybe we should use some other indicator that has remained constant with the same companies.

  • Report this Comment On August 11, 2009, at 7:10 PM, plange01 wrote:

    the greatest false rally since the last depression has ended and stocks are begining to fall as investers begin to realize that we are in another depression and its not going to get better anytime soon...

  • Report this Comment On August 11, 2009, at 9:06 PM, dannytanner wrote:

    the last thing that we would want is for the Dow and S & P to keep going up for the wrong reasons...we are still in for a bit more trouble but Dow 6500 was extremely underpriced..I would be happy to see things stabilize a bit here, then hopefully start the next climb in a few months

  • Report this Comment On August 11, 2009, at 11:57 PM, paultaut wrote:

    Topped? like a New Bear has begun, Topped? or a correction type Top?

    Correction is a probable. The markets bucked the normal "sell in May and go away" but the "as January goes" is still in effect, as is the "October massacre" syndrome.

    In today's markets, I would think that 10% down is easy, personally, I'm looking for 20%.

  • Report this Comment On August 12, 2009, at 2:19 AM, mikecart1 wrote:

    I'd like to see the DOW back to 8000. 6500 is too low and causes too many stocks to fluctuate too much. At 9200 the market is overbought. 8000 is where it should be.

  • Report this Comment On August 12, 2009, at 5:49 AM, plange01 wrote:

    the greatest false rally since the last depression is broken and now we have to face the reality that we are in a depression and its getting worse...

  • Report this Comment On August 12, 2009, at 9:08 AM, Broken196 wrote:

    plange01 keep beating that drum.

  • Report this Comment On August 12, 2009, at 9:49 AM, plange01 wrote:

    the greatest false rally since the last depression is over and now we have to again face the reality that the US is over 8 months into what will most likely be the new great depression before it ends years from now....

  • Report this Comment On August 12, 2009, at 10:26 AM, jesse2159 wrote:

    This market will scrape along the bottom for years to come. My guess is that the DOW is comfortable at about 8500, and there isn't a single valid reason for it to go higher. But, we all know that knee-jerk reaction that comes from any perception of "good news" among the depressing over all picture.

  • Report this Comment On August 12, 2009, at 11:14 AM, Tacomatight wrote:

    plange01,

    Wat u talkin' bout Willis?

  • Report this Comment On August 13, 2009, at 12:14 AM, joandrose wrote:

    The Dow is going up - and it's still got a long way to go to get back to where it was 18 months ago. Stop being so negative - and start to enjoy the ride back up !

  • Report this Comment On August 14, 2009, at 1:43 PM, franksmartin wrote:

    Too many bears out there. Everyone is short or in cash. This market is gonna shock the bears all the way back to Dow 10k and beyond.

  • Report this Comment On August 14, 2009, at 2:40 PM, LookThinkJump wrote:

    The DJIA is a good indicator of the market's mood - mood as in emotion - it is not an indicator of value.

  • Report this Comment On August 14, 2009, at 2:47 PM, tycoon15 wrote:

    You people have me so confused, I just don't know what to do? I'm 50% stocks 50% cash hows that for hedging bets? I really think the fool should make you show how short or long you are, just so we know why you are trying to move the market.

  • Report this Comment On August 14, 2009, at 3:00 PM, midtex100 wrote:

    I started trading stocks for the first time in my life this past Mar 24. Since then, I have daily monotered all the cable TV stock programs, many on-line stock analyst, and certainly Mot Fool. My conclusion is that I haven't got a clue, but neither does anyone else, except that -bad news, stocks go down,- good news, stocks go up. To date, I am up 19.6%, and that includes several terrible mistakes.

  • Report this Comment On August 14, 2009, at 3:10 PM, poracer wrote:

    There are a lot of good stocks with enticing valuations. Personally, I can only invest in what I understand and trust.. This leaves out financial companies, drug makers and a lot of companies in energy.

    The former because they are consumed with self interest, the latter because of manipulation.

    I hope this is the top. Those of us who climbed the wall of worry to profits this year are itching for another go. And, whether it's "THE TOP" is irrelenant.

    The question is risk management. How much more can you make from this level on compared to how much you can lose.

    Have a great weekend

    G

  • Report this Comment On August 14, 2009, at 3:49 PM, sulpolitixmdp wrote:

    Mr. Dumortier brings some excellent historical perspective to this market with this CAPE analysis. However, investors are still uncertain enough and therefore touchy enough, that they will overreact to almost anything and quickly move the market up or down in unpredictable ways. This environment makes it very much a trader's market with all the risk that entails.

    sulpolitix

  • Report this Comment On August 14, 2009, at 5:46 PM, WJMOFFETT wrote:

    Ahh ! is this article suppose to inform me of something. I am always leary of articles titled with a question, rarely is the questions answered.

  • Report this Comment On August 15, 2009, at 12:54 AM, mariocavolo wrote:

    the index is about fairly valued.....

    everyone is playing the game because they have to put their money somewhere and they respond to the fear of being left out...the word "adjusted" is making me vomit...there is little that is realistic about the valuation and P/E ratios being spouted by the media, but everyone has to respond as if they are real....what a mess

  • Report this Comment On August 15, 2009, at 12:55 AM, mariocavolo wrote:

    The Future Your Future: the reason there won't be any financial "collapse/crisis" even though there "should be" is because the way the leaders are "engineering" how they respond to the issues on the table. First and obvious, to prop up the stock markets / banks. Is that evil or wrong or immoral? I'm not sure. Is it a good idea? Damn straight its a good idea! If you were in their shoes, I am certain you would do the same thing! Remember, they are responding to reality and if they "came clean", the world would experience untold financial and economic catastrophic reactions. Secondly, it should be clear to even the casual observer that their wise response is to instead allow a slow, miserable, insidiously sneaky decline of the purchasing power of currencies worldwide. We are living with their strategic choice to allow a hidden steady inflation via relative currency value declines in real purchasing power as, in fact, has been for the past several years. Why you ask? There is NO OTHER WAY to deal with the variety of issues on the table including reducing the cost of the trillions of dollars of toxic debt on the bank's books. So then, the consumer is and will slowly have their purchasing power deteriorate....the policy makers have to go this route, it is really the only route that doesn't include "catastrophe in the news" and also self-servingly preserves their own little world, so to speak

    If I'm right, then the stock market will generally move sideways a bit, continue to rise, then it will "correct" down 30-40 % again and again (maybe it will correct without rising further, it doesn't really matter in the long run) as it always has every few years. Those stock market price cycles from bubble to bust are "normal" not a catastrophe as the news media likes to portray it.

    Stocks will have a certain $$ value, for example, GE will be worth $15, Goldman will be $190, my salary will be $75k per year. The underlying value of the dollars/euros to purchase goods will be lower and lower and lower. That's how the leaders are juggling the variables and settling on strategy to move forward in the least "catastrophic" manner. They ( DaBoyz as they are fondly referred to at Rick Ackerman's website) will not allow the price of gold to fly to the moon, they cannot allow price of oil to collapse to $30, they cannot allow the stock market to collapse; because they can't allow the appearance of crisis.

    You and me then? We simply need to realize that the wisely chosen path of theirs means that we are (as we are) going to get slowly bent over and royally screwed as passive victims of their end game. So then, knowledge is power. We as individuals do have a measure of freedom to respond, the ability to observe, to see the situation as it is, to position ourselves accordingly and carefully, to minimize the damage and deterioration of assets in our own lives, to even benefit and prosper because in some small way, we are smart and wise as they are, not sheep being led to the slaughter. What should we do? Invest in the China boom, play currencies, go long/short certain countries/commodities/sectors/industries. It's up to you to do all that research and lay out your plan. Cheers, Mario

  • Report this Comment On August 16, 2009, at 6:57 AM, japeel wrote:

    Frankly I just don't care. I stopped buying in volume at the beginning of March, when the panic went away and the exuberance started.

    There are still some great value businesses in undervalued sectors, but I really don't like buying when the fell creatures in the hedge funds are abroad.

    I'd very much like to see it all crash again to start buying again.

  • Report this Comment On August 17, 2009, at 9:55 AM, dragracerdad wrote:

    Wow! A lot of mixed sentiment here. Instead of selling off as if the sky were falling, I'm buying smaller lots of stable sectors. Still some undervalued stocks hiding in the weeds. I'm more bullish than bear.

    Responding to comments by mariocavolo, "First and obvious, to prop up the stock markets / banks. Is that evil or wrong or immoral? I'm not sure. Is it a good idea? Damn straight its a good idea! If you were in their shoes, I am certain you would do the same thing!" I'm not a big fan of hand outs. If the man at the helm was allowing wreckless investing and loan allocations then they should pay the price... and be accountable for their actions. I know there is a government agency watching my bank balance and as soon as it gets in the red they are going to send me a check for a $100K to protect my family from failure... fat chance. The bailouts just diluted every one of our dollars. However many seemed necessary to curb rampant havoc. If we go to 9000 today, so be it. Then we'll wait for the next ride up. Welcome to the American Eagle at Six Flags!

    As for comments by japeel, "I'd very much like to see it all crash again to start buying again." Well, ouch and wow,yes! Buying at bargain basement prices is fun as long as you don't have to watch your portfolio hanging out there too. Unfortunately we can't have it both ways.

    I'm in! I'll get off this rollercoaster many years from now and say it was one hell of a ride and glad I had what it takes to stay on. I've just lost 2% already today as I'm typing. I'm only tightening my shoelaces.

    Are you with me?

  • Report this Comment On August 18, 2009, at 7:02 AM, x1x2x3x4444 wrote:

    I am surprised that few people see the reason behind Monday's market decline: the weekend news from the Obama administration that a government-controlled health-care option is not a mandatory part of their plan - all of a sudden, right?

    The reason is simple: U.S. businesses hate providing health-care benefits and see it as a big competitive disadvantage against every other industrialized country. GM opened plants in Canada instead of the U.S. because it didn't have to worry about covering health-care costs. Businesses don't like the fact that U.S. health-care costs continue to go up way ahead of inflation and they are a constant point of contention between management and labor (for those few still unionized workers) and retirees in some cases - and a constant drag on profits.

    No one wants to come out and say it - especially not the Republican clan - but businesses want the government to solve this problem, i.e. take over administration of the nation's health-care services. Corporations know they don't have the clout or organization to do it.

    The Obama administration's sudden about-face on this issue might be a ploy to force business to show its hand - i.e. actually come out and ask for a government-sponsored option. If you think this is crazy, I invite you to watch and listen. Just as the banking (etc.) industry is happy to privatize profits but burden the taxpayer with risk, businesses are more than happy to hand over another trillion-dollar-expense to *the people.*

    Personally, I think they should shelve the health-care issue until our economy recovers. And they should quit the trillion-dollar spending plans. We don't have the money. We are close to being broke. They have no long-term plan. THIS IS ALL RIDICULOUS... or it would be if it wasn't so scary.

  • Report this Comment On August 18, 2009, at 12:59 PM, plange01 wrote:

    with the depression in the US getting worse and 20% of the working population already unemployed crime is the only growth industry left....

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