Dow 20,000: What Will It Take?

The S&P 500 (SNPINDEX: ^GSPC  ) fell 0.2% today, failing to extend its eight-day winning streak. The narrower, price-weighted Dow (DJINDICES: ^DJI  ) was down 0.1%, while the VIX Index (VOLATILITYINDICES: ^VIX  ) closed above 13 for the first time since Jan. 17.

Dow 20,000: Breaking the numbers down
Thomas Lee, chief U.S. equity strategist at JPMOrgan Chase, told CNBC today:

We're at $100 of S&P earnings; the cycle peak in earnings is closer to $150. That really follows the historical pattern of S&P profit cycles. Mid-cycle S&P multiples are at 17 [times earnings]. We're at 13 or 12 and a half. If you put a 17 multiple on $150, the S&P really sort of peaks around 2,400 [or] 2,500.

Meanwhile, he said that is equivalent to the Dow reaching "18, 19, 20,000 -- that's four years away." The Dow at 20,000 would imply a 44% rise over the next four years. Is that reasonable?

Since Lee's argument relies on the profit cycle, let's look at cyclically adjusted price-to-earnings multiples, which are calculated on the basis of a trailing-10-year average of inflation-adjusted earnings per share. On that basis, the average Dow component -- weighted by market value, not price -- is valued at 17.8 times earnings. That compares favorably to the S&P 500 index, which is valued at 22.7 times cyclically adjusted earnings and shows that high-quality, large-cap names (of which Dow components are some of the best examples) remain cheap relative to the broad market.

However, neither set of stocks looks wildly cheap in absolute terms, so if they are to gain 44% and 70%, respectively, in four years (a 70% rise would put the S&P 500 at 2,550), that puts most of the burden on earnings growth. On that front, members of the Dow, which earn a greater percentage of their earnings overseas than the average company in the S&P 500, also look better positioned.

Is Dow 20,000 in the cards within four years? That looks like an aggressive -- but achievable -- forecast. The S&P 500 at 2,550, on the other hand, well, that's closer to fantasy than forecast.

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  • Report this Comment On January 29, 2013, at 1:48 PM, TheDumbMoney wrote:

    I am a fan of CAPE, but I continue to believe it's possible you put a little too much faith in it, or to put that a bit better: I think you don't put it in sufficient context.

    Specifically, I believe it matters more at or near cyclical peaks (before recessions) than it does after a recession. If two CAPE readings are equal, but one reading occurs the year before a large recession, and one occurs four years later, when the recession is over, and profits are just recovering to pre-recession levels or slightly higher while household leverage is less, etc., then those are two readings are not truly equal. Context matters. Patently 2009 was a far better time to invest than 2012 was. But while the jury is still out (obviously we can only know in retrospect whether we ARE at some sort of cyclical peak and nearing a recession), I think we will come to see that even 2012 was patently a better time to invest than 2008 was.

    I understand the critique of my view, but my intuition very stongly tells me it is not correct to treat CAPE in an absolutist manner without taking into account where one estimates one is in a business cycle. I just have not yet worked out the math.

    But since CAPE is based P/E it has to have similar flaws. For example, the most cyclical stocks always look expensive from a P/E perspective when they are at their most investable (2009), and flat cheap when they are at cyclical tops (2007). For that reason, too, the applciability of CAPE as a guide actually seems greater the more cyclical a stock or sector or market is. All stocks/markets are to some extent cyclical, so CAPE always has some applicability. But not all stocks/sectors/markets are created equal in this regard. And there are no silver bullets, not even CAPE.

  • Report this Comment On January 29, 2013, at 3:14 PM, TMFAleph1 wrote:

    "Patently 2009 was a far better time to invest than 2012 was."

    This is clearly reflected in the difference in the CAPE figures over the two periods! I agree with with your broad point that CAPE does not provide certainty and all results are necessarily subject to a degree of randomness; you'll have noticed that I always make an effort to couch my conlusions in probabilistic, rather than deterministic terms. With that said, I know of no better valuation indicator than the CAPE.

  • Report this Comment On January 29, 2013, at 4:36 PM, TheDumbMoney wrote:

    I agree that the 2009 vs. 2012 difference is reflected in the CAPE figues. I didn't mean to imply otherwise and I'm sorry if I did. My point is that similar pre-crisis and post-crisis CAPE figures (though if memory serves we are still below pre-crisis figures) may well be more distinguishable than the pure number figure implies.

    I agree you always speak in probabilistic or otherwise hedged terms, and I appreciate that. Rather than worrying about CAPE, per se, I'm more worried about historically high profit margins and the unknown (to me at least) reasons for them.

    Here's the math I'd like to put together: find the points before and after recent recessions where the CAPE shows a similar numerical figure. Calculate the ten-year returns from each of those two points, onward. It is my hypothesis that the ten-year returns from the post-crisis/rescession CAPE figure will be significantly higher than than for the pre-crisis figure, notwithstanding that the two CAPE figures show similar numbers on their face. Am I wrong? Not sure, haven't done the math yet. Have you? (Serious question.) I think it is implicit in the fact that stocks as a group trend up over the long term at least in the U.S., and that each recession or secular bear market is ultimately followed by greater bursts of growth. Accordingly, I think it would be even more clear if one did the above exercise but looking out 20 years, etc..

  • Report this Comment On January 29, 2013, at 5:18 PM, TMFAleph1 wrote:

    "Rather than worrying about CAPE, per se, I'm more worried about historically high profit margins and the unknown (to me at least) reasons for them."

    Those are two sides of the same coin. The market's current low P/E multiple, based on a earnings-per-share forecast for the next twelve months does not account for the fact that margins are historically high, while the much higher CAPE does account for it.

    "It is my hypothesis that the ten-year returns from the post-crisis/rescession CAPE figure will be significantly higher than than for the pre-crisis figure, notwithstanding that the two CAPE figures show similar numbers on their face."

    I think it depends on which periods you are referring to, specifically. Do you mean a comparison between the peaks and the troughs of the business cycle?

  • Report this Comment On January 29, 2013, at 7:18 PM, TheDumbMoney wrote:

    Maybe it's all nonsense. I'll blog if and when I calculate it. It's about going back to 20th century market crashes and looking at equivalent but high CAPES on either side of each market crash. I think the returns in the chronologically later ones in each set should be higher than for the earlier ones in each set.

    I get that profit margin and CAPE are two sides of the same coin in a sense, but CAPE is more of a technical mean-reversion thing, whereas profit margin is more of a substantive inquiry about what is going on behind it, what is going on in the world. (In part, because of course remember there is also multiple expansion/contraction and sentiment at work in CAPE.)

    I agree CAPE is one of the best quick-look measures around. It is one of the reasons I stopped doing many stock purchases after about 2011 (and maybe I should have stopped earlier, but I'm glad to have picked up the BRK stock I picked up in Autumn 2011). Instead I mostly saved a bunch of money, added 10% as cash-in on my 2010-purchased house so that I could refinance it at 3.75% fixed 30-year in 2012. So that's where my head (and more importantly my money) actually is, though I'm still and always doing my 401k.

    My fascination with CAPE is more about how the John Hussmans of the world floundered so spectacularly on its and other rocky shores (including his Fed hatred) in 2009ish, because even then the CAPE figures did not get spectacularly low.

    And I have my separate concerns about how CAPE is arguably more inherently relevant to stocks like Alcoa and Ford than it is to Johnson & Jonhson or Coke.

  • Report this Comment On January 29, 2013, at 7:23 PM, TMFMorgan wrote:

    <<This is clearly reflected in the difference in the CAPE figures over the two periods!>>

    Only to a point though, right? By December 2009 CAPE was back above 20. The S&P has since rallied nearly 40%

  • Report this Comment On January 29, 2013, at 7:53 PM, TheDumbMoney wrote:

    Yes, that's the Hussman 'problem' I obliquely refer to above. That is part of why he has been basically "fully hedged" (or largely so) for the entire ride up, amidst the "overbought, overbullish, rising yields syndrome." And has in the process torched a huge portion of the long-term outperformance of his primary fund vs. the S&P. This 'problem' exists assuming you think we aren't going to go back to 750 on the S&P anytime soon. Hussman still of course does think that.

  • Report this Comment On January 29, 2013, at 8:10 PM, TheDumbMoney wrote:

    I meant to say Hussman still of course does think we are going back to 750 (not the exact number, but he thinks a major 30% or more drop is imminent). He may be correct. But he has thought it for three or more years.

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