Market Note: Dow 20,000
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The Dow closed above 20,000 for the first time on Wednesday, repeating the feat the following day. There are headlines any time the Dow crosses a 1,000 mark and that’s especially true of this latest milestone. Here’s our take.
First of all, and to state the obvious, 20,000 is just a number, no matter how much those four zeros excite the eye. Still, it’s hard not to ask what, if anything, do such milestones portend for the future. Not very much it turns out. If you look at the performance of the S&P 500 since 1926, it provided a positive return 80% of the time in the year following a new monthly high. Not much different than the 75% of the time it produced a positive one-year return following any month. Obviously, the stock market has a bias toward positive returns, notwithstanding the occasional reversal.
None of this means we can’t make quantitative assessments based on valuation levels, of course, and the Dow and S&P 500 are unquestionably at above average valuations just now. The current price-to-earnings ratio (P/E), a common valuation metric, is about 25 for the S&P 500, versus a long-run average closer to 15. There are two things worth noting: first, this is not a static number; one-year forward looking earnings estimate put the P/E closer to 17. It’s also worth noting that the average P/E is a function of both good periods and bad, with the P/E having sunk as low as 7 during the high interest and inflation rates of the late nineteen seventies. With interest and inflation rates currently low, albeit rising, and the economy chugging steadily along, including a nice uptick in the third quarter of last year, an above average valuation is not that surprising.
A lot of things drive market valuations, and not all of them involve investor expectations for earnings and interest rates. There’s also this thing called “sentiment” that can have a notable influence on valuations. Nonetheless, our starting hypothesis, as ever, is that investors are buying and selling at prices they believe will generate an attractive return going forward. Unpleasant surprises can upend those beliefs and send prices down, but over the long-run, betting against the collective wisdom of the market hasn’t been a winning proposition.
Overseas markets, meanwhile, are still sporting below-average valuations, which could suggest significant upside, especially if higher economic growth finally takes hold. There are headwinds, to be sure. The full effect of the U.K.’s Brexit vote has yet to be seen and is likely to be negative, though that assessment could be confounded if the country can maintain its dominate position in financial services after exiting the EU. It’s easy to stop a bushel of wheat or container of coal at the border, but financial services tend to be delivered over the Internet, where domicile may be less of an issue.
The other developments to watch are elections in the Netherlands, France, and Germany, where populist, anti-EU politicians are making a strong showing. Elections may also be called in Italy before the year is out, so politics will take center stage in the second largest market after the U.S. On the economic front, the EU has a good shot at boosting exports and sparking higher growth if the dollar remains strong. The greenback’s strength has been underpinned by the Fed’s stated commitment to a program of steadily rising interest rates, something that’s likely to continue, though we discovered last week that the new president is capable of sending the greenback into a tailspin with an offhand comment. So this will be another economic variable to watch.
So, enjoy the charts and fun facts that will no doubt fill the weekend papers in honor of the Dow’s latest milestone (it took 76 years to first cross the 1,000 mark!), but know that 20,000 is not a call to action, it’s just a number.