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Stock Market Over Valued, The Real Dow is Trading at 8800 Right Now

Stock-Markets / Stock Markets 2012 Sep 28, 2012 - 10:18 AM GMT

By: Money_Morning

Stock-Markets

Best Financial Markets Analysis ArticleMartin Hutchinson writes: What I have to say today might shock you. But by all historical valuation metrics, the Dow Jones Industrial Index is worth 8,800.

Taking in the recent close of 13,458, that means the Dow Jones is overvalued by 53%.


Let me explain how I arrived at that unsettling conclusion.

Primarily, it's because historically the Dow has risen pretty closely in tandem with nominal Gross Domestic Product.

That makes sense, because corporate profits in the long run have to track GDP fairly closely, and stocks can't soar forever if profits don't follow.

In fact, from 1917 to 1994, the stocks vs. GDP metric practically matched, with periods of overvaluation in the 1920s and 1960s, and periods of undervaluation in the 1930s and late 1970s.

In short, the correlation was nearly perfect for 77 years-until it wasn't.

For this you can thank Alan Greenspan, the erstwhile "Maestro."

The Greenspan Fed Changed the Game
On February 23, 1995 then-Fed chairman Alan Greenspan, in his semi-annual Humphrey-Hawkins Act testimony to Congress, announced that he was ending his period of money tightening that had taken the federal funds rate up to 6% and would start letting rates decline.

Spurred by this news, the Dow Jones Industrial index that afternoon touched 4,000 for the first time.

But at 4,000, the Dow was not undervalued. Loosening the money supply wasn't necessary.

After all, it had peaked at 2,722 only seven years earlier and had then suffered a decline of 1,000 points in a few weeks, including the notorious "Black Monday" crash. At 4,000 it had gone well beyond what in 1987 appeared an unsustainable high, and appeared fairly fully valued.

Of course, Greenspan's Senate testimony did not appear important at first - the Fed had raised and lowered interest rates many times before.

But on this occasion, thanks to more cheap money, the stock market took off.

Within less than two years, by December 1996, the Dow had hit 6,400. Not long after, Greenspan gave his famous "irrational exuberance" speech.

However Greenspan did nothing about what he thought was a dangerously overvalued market, and money supply increased at around 10% per annum between 1995 and 2000.

The result was a spectacular stock market boom unequalled in world history. Irrational exuberance went into overdrive.

So much so that by 2000, I expected the stock market to revert to its 1995 level, which with the increase in nominal GDP in 1995-2000 was equivalent to about 5,500.

However, Greenspan did not want that to happen and, unlike me, he was Chairman of the Fed.

So he cut interest rates savagely, creating a massive housing bubble in the process.

And then when the housing bubble caused the banking crash in 2008, Greenspan's successor, Ben Bernanke, cut interest rates all the way to zero. We've been there ever since. Meanwhile, Bernanke has promised to keep rates at zero into 2015.

As a result, we've had very low interest rates and a very rapid growth in the money supply ever since 1995. The problem is all of this occurred far faster than GDP growth, even including inflation.

Thanks to monetary policy, the train had jumped the tracks.

The Math Behind Dow 8,800
So while GDP has grown steadily since 1995, the cheap money gains in the stock market became bloated and outsized.

Here's why...

Including inflation, nominal GDP has grown about 120% since February 1995. Meanwhile the stock market managed to climb by a whopping 245%!

So if it had matched GDP, as it had ever since 1917, the Real Dow would be standing roughly at 8,800 today.

It only follows that if economic growth continued at its current pace, with say 2% growth and 3% inflation, the "GDP-linked" Dow would catch up to its current level by 2021.

But what about earnings, you say?...

It's true. Normally, you'd expect a Dow that was 50% above its proper level to be abnormally high in terms of both dividends and P/E ratios.

In terms of dividends it is; the Dow Jones index currently yields 2.5%, lower than the 3.2% yield at its peak in 1929. However in terms of earnings the Dow Jones P/E ratio at 14.6 times is just around the long-term historical average.

That's because earnings themselves are in a huge bubble. Indeed, the ratio of corporate earnings to GDP is currently at an all-time high, higher than at its peak in 1929 and much higher than it was in 2000.

There are several reasons for this bubble, such as the profits from outsourcing that large international companies have enjoyed in recent years, but the main cause is low interest rates.

If half a company's balance sheet is debt, then ultra-low interest rates, by reducing the cost of debt, will increase earnings. Needless to say, outsourcing profits can be expected to decline as emerging market wage levels rise, and ultra-low interest rates won't last forever.

That's why expected returns to investors are so low these days-about 6% per annum compared to 9-10% in the 75 years to 2000.

The truth is all the profit from the Dow's rise between 1995 and 2012 was concentrated into the first five years of the 1990s stock market bubble. Since 2000, the real Dow has appreciated only modestly.

Now faced with the prospect of interest rates rising sometime in the future and outsourcing profits that start to decline, the Dow likely won't increase much this side of 2021.

The good news is that this comatose market won't last forever. Once rising GDP has caught up to the Dow around 2021, the market and the economy will once again increase in tandem.

However we should understand - investors don't have to wait that long to start making money again.

Depending on your situation, it's possible to reap anywhere from $1,000 to $10,000 a month in any market-up, down, or even flat.

What's more, you could double that with one little step I detail here.

The point is, you don't have to let this bubble market suck your life savings down the drain.

Otherwise, you'll be in for a quite a long wait before the next real bull market returns.

Source :http://moneymorning.com/2012/09/28/the-real-dow-is-at-8800-right-now/

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