Monday, November 15, 2010

Dow Worth 15,000?

Does the Dow trading at 15,000 sound crazy? That's probably the general consensus in the market these days. The Dow currently trades at 11,201 at the close today.  A 3,800 point jump to get to 15,000 amounts to a 34% gain. What's interesting about he concept of the market currently being worth X amount higher or the future value hitting X in a year is that the market commentary is almost completely void of future predictions with the market higher.

It's very bullish to turn on the TV or pull up a blog and see the latest prediction of the SP500 plunging to 900 or 600 or even lower. After a decade of the market being basically flat (ok it was very volatile in that period), most market pundits seem fixated that the market won't ever go higher. Corporate earnings have peaked if you listen to them. Heck, if you had listened to the pundits corporate profits would've never rebounded so sharply.

This brings us to one of our favorite economists, Brian Westbury at First Trust. Brian has consistently been bullish preaching the concept that the economy is better then people think. This morning he posed on his blog that the Dow should currently be worth 15,000. Actually at these interest rates, he speculated that the Dow should actually be worth 27,000. Since rates are artificially low, First Trust rightfully suggests that a 5% 10 year yield should be used in the model. If the market was to rise to the 15K level, the 10 year would surely exceed 4% and likely hit the 5% target. Remember its sub 3% now.

The best news for bulls is that First Trust and Brian get very little publicity for such a bullish prediction. In fact, watch any of his TV appearances and the commentators are usually trashing his bullish stance. Its a good reminder for all the people on the sidelines. The risk isn't always that the market will drop. In fact, the likely biggest risk is being still on the sidelines and missing the next leg up.  Possibly the leg up that leads the market to new all time highs as crazy as that sounds. After all, corporate profits are already at record highs and SP500 earnings per share will quickly approach the highs in 2011.


First Trust Analysis:

  • We use a capitalized profits approach to valuing stocks.  It’s relatively simple – divide (discount) the government estimate of corporate profits by the 10-year Treasury yield, compare the result to each quarter for the past 60 years and use it to find an average fair value for stocks.
  • Using current 10-year yields (which are being held artificially low by the Fed) gives us a fair value for the Dow of 27,000.  Wait!  Before you write us off as crazy, we do not believe that this result is correct.  The reason the model kicks out such a high number is because Treasury yields are so low.
  • But, bonds are overvalued.  With nominal GDP running above 4% growth in the past year, we think a 2.8% yield on the 10-year is too low – so we use a 5% yield in the model.  This provides a “fair value” estimate of 15,000 on the Dow, which will rise as corporate profits grow.
  • As a stress test, we estimate what yield would make the Dow fairly-valued right now.  That number is a 10-year yield of 6.75%.  And, remember, even with interest rates at this level, any gains in profits would send the valuation level higher.  And profits look set to continue their strong performance.

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