The Dow passes a milestone that is not all it seems

The Dow passes a milestone that is not all it seems
By John Authers
Copyright The Financial Times Limited 2006
Published: October 4 2006 19:11 | Last updated: October 4 2006 19:11



The new all-time high set by the Dow Jones Industrial Average on Tuesday was truly remarkable. How on earth did it take it that long?

After it last reached a high, on January 14 2000, the US suffered a very brief recession and then carried on growing as before. Corporate America did far better than the country as a whole, with companies cleaning their balance sheets, making cuts and taking advantage of capital expenditure investments made during the late 1990s. That earnings boom has continued unabated now for 14 successive quarters.

Thus celebrations seem misplaced if the Dow, still without much doubt the world’s best-recognised index, has set a new record. Further, the Dow comes with a number of health warnings. It contains only 30 stocks, which are not representative of the US economy. It is weighted according to share price rather than to market value, which can create perverse results, and it regularly drops companies that are not performing well (examples in the past decade include Bethlehem Steel, Westinghouse and Eastman Kodak).

For all these reasons, several indices are more closely watched, notably the S&P 500, maintained by Standard & Poor’s, the rating agency. The more consistent data for the S&P 500, which is still 9 per cent below its level of January 14 2000, make it much easier to use for the purpose of analysis. This is a reasonable compromise – over history, the Dow and the S&P have been closely correlated, although the Dow has done better over the last few years in large part because it missed out on the late 1990s technology boom. (The Nasdaq Composite, where most tech stocks resided, is still at less than half its peak).

So why has it taken the Dow so long to reach its heights of 2000? Fundamentally, the world is prepared to pay much less for the earnings of large US companies now than it was then.

Since US corporate profits troughed in the final quarter of 2002, they have risen every quarter since. Earnings per share in the second quarter of this year were 170 per cent higher than their level then, and 55 per cent higher than in the final quarter of 1999. But almost one for one, every dollar that US companies have added to their earnings has been matched by a reduction in the multiple that the market is prepared to pay for those earnings. The S&P traded at a price/earnings ratio of 28 at the beginning of this decade – it now trades at a multiple of 16.

This is partly a reaction to the excesses of that era. The P/E ratio of the S&P reached the absurd level of 46 by the first quarter of 2002 – triple its level of 1995. So some of the steady collapse of the P/E ratio since then is a simple return to historically sustainable valuations.

Next, there is the profound effect of the terrorist attacks of September 11 2001, which increased the perceived level of geopolitical risk (and hence reduced the amount that investors were prepared to pay for US stocks compared with other securities). The psychological impacts of 9/11, while incalculable, were probably also significant, bearing in mind how many US stock traders were direct witnesses to what happened.

Third, the interest rate backdrop changed. Many analysts complain that there was an effective “Greenspan put” during Alan Greenspan ’s long tenure as chairman of the Fed. By this, they meant that he would always come to the rescue with lower rates if the stock market ran into trouble. As 2000 dawned, the Federal Reserve had been flooding the markets with liquidity in an attempt to guard against the possibility of a major blow to the financial system from the “Y2K” problem. Later, after the bursting of the technology bubble, interest rates reached the historically low level of 1 per cent in June 2003.

Over the past two years, the Fed has pursued an aggressive campaign of monetary tightening, in which it has only just declared a pause. When rates are higher, standard discounted cashflow analysis dictates that the value of a company’s future earnings should be discounted at a higher rate, and hence that the company is worth less. Higher interest rates also increase the costs of managing corporate debt.

Another important factor was the series of financial scandals that followed the collapse of Enron in late 2001. These shook confidence in the corporate sector, forced many companies to restate their earnings downwards as their accounting came under fresh scrutiny, and led to the Sarbanes-Oxley corporate governance legislation. Many companies complain that this has been too onerous.

Then there is the global macroeconomic context. The dollar has weakened significantly since early 2000. This has meant that, for most foreign investors, the Dow is still nowhere near its level of January 2000: it is down more than 13 per cent in sterling terms, 20 per cent in terms of the euro, and 22 per cent in terms of the Swiss franc. When the currency is expected to weaken, investing in US stocks is less attractive.

Large-cap stocks in general, particularly conglomerates, went out of fashion. With the US in a bear market, investors were more prepared to look further afield. Since 2000, the IPC index in neighbouring Mexico – which has been no star over this period, enduring several years of economic stagnation followed by muted growth – has grown 193 per cent.

A final obstacle to growth in equities came from events in other markets. Commodities embarked on a historic bull run just as the US equity indices were reaching their lowest level in 2002. This affected US equities both by attracting away speculative dollars and by increasing companies’ production costs. West Texas Intermediate crude has risen 117 per cent in price while the Dow has stood still. This was great news for energy companies, but their sole representative among the 30 Dow stocks is Exxon Mobil.

For those who view gold as the only true hard currency, the Dow is still at less than half its previous high, because the metal has gained 110 per cent since then.

The fuel that has propelled the Dow forward in the last few weeks has come from the reversal of several of these factors. Oil prices have dropped about 25 per cent since they peaked in July. The Fed left rates unchanged at its last two meetings, while the market is now placing a strong bet that the next move in rates will be downwards.

There are also signs that the appetite for risk is diminishing. Emerging Portfolio Fund Research of Boston reports that emerging markets funds have suffered outflows for the last five weeks. Big US stocks have actually outpaced their smaller counterparts in recent months, while the spreads payable for buying emerging market debt rather than US treasuries have started to widen.

Another factor is fresh confidence that the US can achieve a “soft landing” – also known as the “Goldilocks scenario,” where the economy is “not too hot, not too cold”. But that does not mean that fresh highs for the Dow are assured. A lower oil price could presage lower demand, which would imply a slowdown. The same can be said for interest rates and bond yields.

Finally, the earnings expansion has already lasted a long time. The sudden fall in the oil price will probably help profits for the quarter just finished. But if earnings start to slow, the Dow might have to put up with another protracted period of moving sideways.