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:


% Return Since June 30

2010 Est. Price-to-Earnings Ratio

American Express (NYSE:AXP)



Caterpillar (NYSE:CAT)






Cisco Systems (NASDAQ:CSCO)



DuPont (NYSE:DD)



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):



P/E (2009 est. earnings)


P/E (2010 est. earnings)


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


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.

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