nobody wants to hear this right now but here it is
Dow 10,000 is irrelevant..........The index tells very little about stocks and not nearly enough about value. Dow stocks and stocks in general are priced for a perfect world -- in a world that's far from perfect.
By Bill Fleckenstein
What does Dow 10,000 tell us? By itself, nothing. Without other information, the price alone is irrelevant. It's like saying that a bond trades at par. Without knowing the coupon, there's no way of determining whether it's attractive or not. If the coupon rate on a bond were 1%, you'd probably have little interest, but if it were 10%, you might be very interested.
So it is with stocks (or an index of stocks, like the Dow ($INDU)). At one level of earnings, a particular price might seem expensive. At another, higher level of earnings, the same price might be very attractive. That so many people focus just on the price of an index like the Dow and not on the value underlying the index speaks volumes about how speculative the current investment environment continues to be. A bond can't be evaluated only by knowing its price, and neither can a stock or an index.
Yet, far too many people continue to focus only on price and other sound bites, including:
* The market will experience a seasonal rally.
* The market goes up in the third year of a presidential-election cycle.
* The stock is up because the company beat the estimates.
None of that has anything to do with investing. It's just speculating.Money 2004.
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The real key is value
Since the market peaked in 2000, millions of people have suffered large losses, discovering that notions like stock splits, Internet companies and other "great" concepts ultimately do not yield profitable results. And yet today, too many people still know the price of everything and the value of nothing.
Investing is about buying value and building a margin of safety. The Dow at 10,000 offers neither.
The Dow's price-to-earnings ratio (P/E) is somewhere between 20 and 25, the S&P 500's ($INX) is between 25 and 30, and the Nasdaq ($COMPX) comes in at around 195. We can't say exactly what these ratios are, because it depends on how exactly we want to calculate trailing earnings. Generally, we have a pretty good idea about the past, while we don't often have a very good idea about the future. (On Wall Street, it seems, folks are always certain that the future will produce higher earnings, even though the future doesn't always cooperate.)
Future? It's even hard to tell the past
In any case, in recent times there have been so many recurring one-time charges for so many companies every quarter that it's hard to even get a handle on what the true level of earnings has been.
Still in all, there is much that we can learn from these approximations. Assuming a Dow P/E of 21, if we were to acquire the entire index, we'd get our money back in 21 years. (Along the way, we'd also get a dividend of about 2%, barely enough to keep up with even the Fed's low definition of inflation.)
That 21 years assumes no growth of earnings and no diminution of same. The break-even time would obviously be a bit longer for the S&P, and nearly an eternity for Nasdaq. I'll leave it to you to decide what you think the growth in earnings would be, but even Warren Buffett has said recently that he finds little value today. For those who assume that low interest rates necessarily result in high P/Es, I say look at Japan. If rates are low because business is poor, higher P/E's compound the risks.
Taking a slightly different approach, we could look at the entire stock market capitalization as a percentage of gross domestic product. The percentage is now about 105% of GDP. That number alone doesn't mean anything. But what if I were to tell you that, before the bubble began in 1995, the highest the percentage had ever been was 80%? You could see that if we just traded back to the highest previous level, we would experience a decline of 25% in the Dow. Likewise, if I told you that, for the last 75 years or so, the stock market’s total capitalization has averaged about 55% of GDP, you could see that to get back to the average level we've traded at would imply a decline of about 50%. We won't even discuss what would happen if we were to trade back to lower levels of valuation.
Priced for a perfect world
Today's P/Es are very high historically -- the kind you might expect to see in a perfect, problem-free world. They are also the kind we saw when people were deluded into believing that we'd entered a new era. Those misguided folks failed to understand that we can never have new eras because human nature never changes.
Despite the fact that the world is far from perfect, the valuations seen today suggest the world is perfect and there is nary a cloud in the sky.
However, today there are many clouds. In no particular order:
* Jobs are still difficult to come by as the bubble's aftermath makes a self-sustaining recovery less likely.
* The economy’s weakness has translated to empty coffers for many state and local municipalities.
* We recently saw personal bankruptcies hit a record.
* The dollar has lost more value in the last two years than it did in 1986 or 1987. This year, in fact, it has lost more than it did in 1987, even after the crash. This matters, because as a country, we are a net debtor to the rest of the world.
* Domestic debt has piled up to the tune of $35 trillion -- the highest ever, at 3.5 times GDP.
* Likewise, we have bubblelike conditions in housing. The risk there is not so much in prices themselves but in the leverage folks have assumed in trying to live beyond their means, as they have tried to deal with the aftermath of the previously mentioned bubble.
* Further, we have learned that much of corporate America is not to be trusted, nor is Wall Street, and we are now learning about new problems with mutual funds. On top of that, it turns out that maybe the Securities and Exchange Commission doesn't have a staff big enough to police everything.
Though the landscape I have sketched strikes me as particularly risky, today's speculators think that risks are low, simply because prices are high. They naively believe that rising prices beget more rising prices -- because in the short run, they have. They will likely sell to real investors when prices are low. Too late, they will finally realize that risks are high. The new buyers will be compensated for those risks by lower prices, making their investment risk low. (For the new buyers, the lower prices produce a margin of safety that mitigates risk.)
In sum, the market is priced for perfection, and the environment is anything but perfect. This doesn't mean that the market can't trade higher. It can. But it means that the risks to those who want to play the game are extremely high, whether they realize it or not, and their chances of investment success are very low.
Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. |
