This Dow Goes To 11 (Thousand) -- and Can't Be Played Higher
"And just like that, he's gone." -- Kevin Spacey, The Usual Suspects
While not quite as elusive as Keyser Soze, the 11,000 mark on the
Dow Jones Industrial Average is one the market has had a hard time holding on to. Since first crossing the threshold in May 1999, there have been 19 streaks where the Dow has closed above this figure only to fall back below it. (At midday, the Dow was at 10,665.17.)
When the Dow has slipped far below the mark, such as in March when it briefly dropped to 9100 intraday, that hasn't lasted either. For about two years now, the Dow has created an oblong, Pluto-like orbit with the 11,000 figure, never managing to hold fast above it nor trip far below it. In the past week, the Dow has once again waved goodbye to this figure. While it may climb above the mark again, all indications show the Dow's dance with 11,000 will continue for a while.
"Since March 1999, there's really been nothing going on," said Gary Kaltbaum, technical strategist at
First Union Securities
. "I suspect it's going to stay this way. It's a matter of earnings catching up with valuations, and it takes time. If you look at a long-term chart, you can tell this needs to happen. It has to go back to normality, either through a drop or with time."
The 11K mark, which really doesn't have any special significance, may be the center of gravity for the average for a spell -- the duration of the year, if not longer. The reasons aren't overly technical; it's just that the 30-stock average's surge coincided with one of the strongest periods of economic growth of the post-war era. (An earlier
story by
TSC's
Diane Hess
took a more sanguine view of the Dow's move past 11,000.)
But the economic picture has become increasingly muddled. Inflation is no longer nonexistent, as it was for much of the decade; profit margins have eroded, and overall economic growth has slumped. Significant improvement in earnings, even if economic growth rebounds, isn't expected.
Meanwhile, the current
price-to-earnings ratio of the 30-stock average is still a bit high by historical standards, although the recent selloff has pushed it closer to the historical mean. That doesn't make for much of an argument for the market to leave 11K in the dust.
History Lessons
The current market situation follows a period where the Dow and other major averages, for the most part, assumed a vertical position. There have been several periods like this in history; strong advances in stocks ultimately create overvalued stocks -- and they're generally followed by a period where stocks step sideways for a longer period of time than anyone thinks possible.
That was true for the bulk of the stock market in the '70s and the '30s. It may be true now as well (though analysts don't figure the Dow is headed for a 1929-1942-type slump).
The counterargument here is, this sideways movement has already lasted for two years, and history isn't always the best guide. Just as history wouldn't tell anyone that 2000 and half of 2001 would be mostly a wash as far as stocks go, it doesn't necessarily follow that we're in for several more years of nowhere land.
Which is why analysts look more closely at current fundamentals expressed in the Dow Jones Industrial Average and conclude the market is still discounting too much in the way of improvement. The current 12-month trailing P/E multiple on the Dow has dropped to 20.3, but the post-war mean is 17.
OK, so it's not wildly overvalued anymore, but this isn't 1999, when the sheer volume of money in the system prompted higher P/E ratios and outlandish outlooks.
The money is gone, but the psychology that grew from it isn't and investors are taking a couple of great leaps at this point. One, they're assuming that earnings growth will match expectations and justify higher prices.
Second, they're ignoring the changes in the economy from two years ago, when favorable supply-side price events and rising productivity meant costs were low and profit margins soared. But those earnings-boosting factors are being eroded in this sluggish environment. The favorable supply shocks, such as falling medical costs, exceptionally low oil prices and low labor costs aren't present anymore. Businesses aren't investing and profits are falling, and that situation won't change with a few
Fed
rate cuts.
It's All About the Profits
"Saved by the Fed" was enough of a story to lift stocks from their trough in April, but that alchemy -- improvement based on Fed cuts and a tax cut -- isn't enough at this overvalued stage. Ultimately, though, what matters to the stock market is improvement in earnings.
"What would be announced that could drive stocks up?" asks Phil Dow, head of investment strategist at
Dain Rauscher
. "We've got every macro indicator you can think of except for earnings ... but we don't have any anecdotal evidence of the channel getting stronger. We want the real thing, and we may not be getting it for a while."
For months, the bet has been on the fourth quarter. Currently, it's expected that the
S&P 500
earnings growth rate will be 7.2% in the fourth quarter (revised down from April's 12.3% estimate). With profit margins having dropped dramatically and business investment stopped in its tracks, those expectations are suspect and subject to more downward revision. Rallies built on that foundation should be viewed similarly.
Chuck Carlson, editor of
Dow Theory Forecasts
, notes that few of the Dow stocks "are screaming values." He says, "I don't know if the earnings improvement is enough to support the valuations you're seeing right now."
Having dropped 300 points in the past week, investors might start to re-evaluate that thinking. Then, the Dow could taste 11,000 again ... but then what?