What's the Fair Value for the Dow Jones Industrial Average?

This week the market is all gloom and doom. PIMCO’s Bill Gross thinks that the Dow’s fair value should be 7,000. GMO Chairman Jeremy Grantham also believes that the U.S. stock market is almost 25% above fair value.

I went through all DJIA component stocks (Dow 30) to find out what the fair value the Dow is.

The Dow Is Not a Bargain, But It's No Bubble Either

To calculate the DJIA, the sum of the prices of all 30 stocks is divided by Dow Divisor, which is currently 0.132319125.

Name (Symbol)	Price	EPS (ttm)	P/E	EPS E (next yr)	Forward P/E
3M COMPANY (MMM)	$73.6	$4.0	18	$4.8	15
ALCOA INC (AA)	$12.4	-$2.3	n/a	$0.6	23
AMER EXPRESS (AXP)	$34.8	$1.2	30	$2.2	16
AT&T INC. (T)	$25.7	$2.0	13	$2.2	11
BK OF AMERICA (BAC)	$14.6	$0.1	166	$0.8	19
BOEING CO (BA)	$47.8	-$0.1	n/a	$4.4	11
CATERPILLAR (CAT)	$55.1	$2.1	26	$2.7	21
CHEVRON CORP (CVX)	$76.5	$8.1	9	$7.5	10
Cisco Systems (CSCO)	$22.8	$1.1	22	$1.5	15
COCA COLA CO (KO)	$53.3	$2.7	20	$3.4	16
DU PONT (DD)	$31.8	$0.7	43	$2.2	14
EXXON MOBIL (XOM)	$71.7	$6.2	12	$5.9	12
GEN ELECTRIC (GE)	$14.3	$1.1	13	$0.9	16
HEWLETT PACK (HPQ)	$47.5	$3.0	16	$4.3	11
HOME DEPOT (HD)	$25.1	$1.4	18	$1.7	15
Intel Corporation (INTC)	$19.1	$0.4	46	$1.5	13
IBM (IBM)	$120.6	$9.7	12	$10.9	11
JOHNSON & JOH (JNJ)	$59.1	$4.6	13	$4.9	12
JP MORGAN CHA (JPM)	$41.8	$1.6	26	$3.2	13
KRAFT FOODS (KFT)	$27.5	$2.1	13	$2.2	13
MCDONALDS (MCD)	$58.6	$3.9	15	$4.4	13
MERCK CO (MRK)	$30.9	$3.8	8	$3.4	9
Microsoft (MSFT)	$27.7	$1.5	18	$2.1	14
PFIZER INC (PFE)	$17.0	$1.2	14	$2.2	8
PROCTER GAMB (PG)	$58.0	$4.3	14	$4.0	14
THE TRAVELERS (TRV)	$49.8	$5.4	9	$5.7	9
UNITED TECH (UTX)	$61.5	$4.2	15	$4.5	14
VERIZON COMMUN (VZ)	$29.6	$2.0	15	$2.5	12
WAL MART (WMT)	$49.7	$3.4	15	$3.9	13
WALT DISNEY (DIS)	$27.4	$1.7	16	$1.9	15
TOTAL/AVERAGE	$1,285.1	$81.0	16	$102.4	13

Average P/E is 15.9. Forward P/E is even lower. Historically, the market is viewed to be overvalued when P/E ratios move above 18.

Following metrics are scenario analysis, which list the potential Dow value base on different P/E and EPS:

P/E	EPS (ttm)	EPS Est (curr yr)	EPS (next yr)
Dow	$81.0	$84.5	$102.4
14	8,570	8,936	10,835
16	9,794	10,213	12,383
18	11,019	11,489	13,931

The inverse of 14x earnings is a 7.1% yield, which is more than double the U.S.10 Year Treasure yield. Based on next year’s estimated EPS and P/E of 14, I will not be surprised to see the Dow go as high as 10,835. But if you use trailing twelve months (ttm) EPS, the Dow could be 8,570.

This rally went “too far, too fast”. The market might be overdue for a short-term painful pullback for the following 3 reasons:

1. Recovery Driven By Government Spending

Fueled by government stimulus, the U.S. economy grew last quarter for the first time in more than a year. Aggressive stimulus debt must be repaid at some time. All government spending must be financed through some combination of taxation, borrowing and inflation. Any government’s ability to borrow and tax is limited. If massive and growing federal debt is to be paid off through higher taxes, the outcome could be a period of economic stagnation similar to Japan’s “lost decade”, according to an article in Financial Analysts Journal Sep/Oct 2009 issue.

2. Consumer Spending Is Down

U.S. consumer has lost substantial value. The unemployment rate of 9.8% is the highest since June 1983 and payrolls had dropped for 21 consecutive months. No meaningful recovery can occur when incomes and jobs are falling at such rate.

The one sure thing for retailers is value. “Value has moved firmly from accessory to necessity. Retailers with a convincing value proposition will fare best during the year-end holidays.”

3. Broken Financial System

Despite much improvement, conditions among U.S. financial institutions remain troubled and lots of them are effectively insolvent.

Protect Your Portfolio With Short ETFs

Followings are top 4 short ETFs with net assets over $1 billion:

Fund Name	Ticker	Assets
UltraShort S&P500 ProShares	(SDS)	3.44B
Short S&P500 ProShares	(SH)	1.48B
Direxion Daily Financial Bear 3X Shares	(FAZ)	1.18B
UltraShort QQQ ProShares	(QID)	1.05B

These short ETFs offer a short-term hedging tool and a way to profit from declines. They can play a useful role in a conservative portfolio. They work fine for a short term, but the perpetual compounding creates havoc over long period of time. In other words, they are for trading, not holding.

Conclusion

With interest rates near zero and government’s stimulus, the Dow is fairly valued. However, the economy might be substantial weaker ahead and last 8 months rally might be just based on cost-cutting or hope. If you are nervous about potential correction, you might use short ETFs to insure your portfolio. Thus if the pullback do happen, you’ll be well prepared.

Warren Buffett’s Berkshire Hathaway (BRK.A) owns 9 Dow component stocks: AXP, BAC, GE, HD, JNJ, KFT, KO, PG and WMT. Those holdings account for around 50% of BRK-A’s portfolio. This should give you peace of mind if you are a disciplined long-term value investor.

Disclosure: I have long positions on MCD, SDS and WMT. All data is from Yahoo Finance as of Oct 30, 2009.

Comments

[J Clinton Hill:]

i normally don't comment on comments for other bloggers, but as a proponent of free market capitalism, i philosophically disagree with your proposed solutions...

such measures would highly restrict the freedom of choice and flow of capital to both competitive or even more consumer/friendly business models...

in essence, it would be akin to shooting ourselves in the stomach just to get to the predators who stalk us from behind...

if you are searching for a utopia or sugar tit in the sky, you might be better off relocating to venezuela or someplace similar if you're really serious about this..


On Nov 01 07:01 AM apppro wrote:

> What happened this week is just another and perhaps best/final case
> into why we must stop this short-term option trader/traitor mentality
> & trading. I’ll be the first to admit that maybe the DOW and
> S&P have as some have complained, “Gone too far in too short
> a period of time!” Without going back to my original argument that
> they’re basing that moronic statement on a level we should have NEVER
> been at in the 1st place, let’s just say that maybe the markets have
> gone a little higher then maybe their actual worth is based on. As
> to whether the DOW or other indices are fairly valued, I give your
> opinion above worth noting.
>
> For me I take a far longer view. We’ve taken out all the added fluff
> that they say was added with all that leverage since 2004, and actually
> we’re even back to 1999 levels. Fair? Doesn’t sound fair to me, but
> that’s what we allowed to be done.
>
> Just look at this past week’s chart of JPM Chase.
>
> finance.yahoo.com/echa...;range=5d;indicator=vo...
>
>
> Monday and Tuesday were ok and non-events on no news. On Wednesday
> the entire market sold off at the open and never recovered. The news
> again was really a non-event, but some media pundits & traders/traitors
> brought back that ‘double deep’ crappola and fear spread throughout.
> Thursday reality set back in when GREAT GDP and just ok employment
> #’s came out.. the markets recovered, but those traders/traitors
> couldn’t let it go. CNBS had a parade of naysayer pundits on the
> show Friday morning and when basically so-so spending and income
> numbers came out at 8:30 am (These numbers were exactly as expected
> and should have been a non-event.) the short-term option traders/traitors
> had worked everybody up into a sell-off mode and things never looked
> back. 250 points down on the DOW and major levels breached. It was
> a pure disgrace. They tried to blame it on the dollar, on the consumer,
> on anything they could grab a hold of; but when it comes down to
> it, the sell-off was a well orchestrated, end-of-the-month options
> traders/traitors manipulated disaster.
>
> You may ask, “Why should I care? I’m not in the market or I own mutual
> funds, why should this matter to me?” It matters because you may
> be one of those lucky people who still has a job, or one of those
> still trying to find one... all these swings and angst are not healthy.
> They make everyone so full of fear and uncertainty that no one can
> muster up the desire to spend, invest, invent, inspire, etc. And
> don’t make the mistake of thinking that CEO’s of big companies are
> any different. I told you before, you keep bashing someone over the
> head over and over; sooner or later they will break! This is especially
> true of small businesses, the major driver of employment in the U.S.
> Would YOU spend thousands or go into debt to start a new business
> if every 5-minutes someone else is telling you that everything will
> crash in the next 10-minutes? I don’t think so!
>
> Whether you’re a Republican or Democratic, whether you’re a capitalist
> or socialist, whether you’re a ying or a yang; we MUST ALL start
> to agree upon ONE THING and that is this short-term mentality and
> trading MUST END!
>
> STOP THE INSANITY NOW!
>
> Revised Tax Rules:
>
> 1. Capital gains under <6 months - 55% tax on capital gains
> 2. Capital gains 6 > 12 months - 45% tax on capital gains
> 3. Capital gains 1 > 2 years - 35% tax on capital gains
> 4. Capital gains 2 > 5 years - 18% tax on capital gains
> 5. Capital gains 5+ years - 5% tax on capital gains
> 6. Most critical of all — Institute a capital gains tax of 55% on
> ALL short sales not directly tied to a long buy by a licensed hedge
> fund. I'm tired of paying for the pure shorts 3rd vacation home.

Nov 01 12:32 PM

[apppro:]

<<So why would any reasonable investor want the government to have further sway in their financial well being?>>

Our government screws everything up, that is for sure. However, we must deter or even stop all this short term trading and the mentality behind it. It produces NOTHING and saps the financial strength out of our economy. Without regulating anything, except hopefully our behavior, decreasing tax rates to promote long term investing and vice versa - we can only think that it would help reduce the insanity. The IRS got Capone, let them go after the other traders/traitors.

On Nov 01 09:44 AM Walt17 wrote:

> I do not agree with that!
>
> Your suggestion implies that you want the government to control how
> we invest. Our government has not given me any reason to believe
> that letting them dictate my trading strategies would be to my best
> interest.
>
> Whether you’re a Republican or Democratic - What must end is the
> notion that government can make everything better. They have repeatedly
> demonstrated an inability to do that. So why would any reasonable
> investor want the government to have further sway in their financial
> well being?
>

Nov 01 05:58 PM

[StockMaster...:]

There are a lot of moving parts to where the DOW could go that this doesn't touch on. Where is your money going to go if the dollar declines in value? Stocks are better than money market and US earnings will improve because 40% of the S&P profits come from overseas. Also, I doubt they raise interest rates anytime soon and here is why: this low interest rate environment is basically the only ammo they have to stimulate jobs. Over the last 10 years most of our jobs went overseas and we can't stimulate them back like we did in previous recessions because no one will work for $4 an hour in the USA.

Nov 01 08:30 PM

[untrusting ...:]

Ok, just curious as to where and when you have ever seen "free market capitalism"? We have seen plenty of oligarchs, kleptocrats, croony capitalists, pseudo capitalists, big money lobbyists claiming to be capitalists, fraudster company executives dreaming they are capitalists, etc, and even some communists, socialists, and facists ...... but not sure we have ever seen any real "free market capitalism".


On Nov 01 12:32 PM J Clinton Hill wrote:

> i normally don't comment on comments for other bloggers, but as a
> proponent of free market capitalism, i philosophically disagree with
> your proposed solutions...
>
> such measures would highly restrict the freedom of choice and flow
> of capital to both competitive or even more consumer/friendly business
> models...
>
> in essence, it would be akin to shooting ourselves in the stomach
> just to get to the predators who stalk us from behind...
>
> if you are searching for a utopia or sugar tit in the sky, you might
> be better off relocating to venezuela or someplace similar if you're
> really serious about this..

Nov 01 08:54 PM

[Jim Bob Jones:]

So, let's all hold long term and give Wall street another chance to drain our piggy? I do'nt think so! Trade short term , follow the trend and protect your wealth unlike the so called knowledgeable banks and brokers.


On Nov 01 07:01 AM apppro wrote:

> What happened this week is just another and perhaps best/final case
> into why we must stop this short-term option trader/traitor mentality
> & trading. I’ll be the first to admit that maybe the DOW and
> S&P have as some have complained, “Gone too far in too short
> a period of time!” Without going back to my original argument that
> they’re basing that moronic statement on a level we should have NEVER
> been at in the 1st place, let’s just say that maybe the markets have
> gone a little higher then maybe their actual worth is based on. As
> to whether the DOW or other indices are fairly valued, I give your
> opinion above worth noting.
>
> For me I take a far longer view. We’ve taken out all the added fluff
> that they say was added with all that leverage since 2004, and actually
> we’re even back to 1999 levels. Fair? Doesn’t sound fair to me, but
> that’s what we allowed to be done.
>
> Just look at this past week’s chart of JPM Chase.
>
> finance.yahoo.com/echa...;range=5d;indicator=vo...
>
>
> Monday and Tuesday were ok and non-events on no news. On Wednesday
> the entire market sold off at the open and never recovered. The news
> again was really a non-event, but some media pundits & traders/traitors
> brought back that ‘double deep’ crappola and fear spread throughout.
> Thursday reality set back in when GREAT GDP and just ok employment
> #’s came out.. the markets recovered, but those traders/traitors
> couldn’t let it go. CNBS had a parade of naysayer pundits on the
> show Friday morning and when basically so-so spending and income
> numbers came out at 8:30 am (These numbers were exactly as expected
> and should have been a non-event.) the short-term option traders/traitors
> had worked everybody up into a sell-off mode and things never looked
> back. 250 points down on the DOW and major levels breached. It was
> a pure disgrace. They tried to blame it on the dollar, on the consumer,
> on anything they could grab a hold of; but when it comes down to
> it, the sell-off was a well orchestrated, end-of-the-month options
> traders/traitors manipulated disaster.
>
> You may ask, “Why should I care? I’m not in the market or I own mutual
> funds, why should this matter to me?” It matters because you may
> be one of those lucky people who still has a job, or one of those
> still trying to find one... all these swings and angst are not healthy.
> They make everyone so full of fear and uncertainty that no one can
> muster up the desire to spend, invest, invent, inspire, etc. And
> don’t make the mistake of thinking that CEO’s of big companies are
> any different. I told you before, you keep bashing someone over the
> head over and over; sooner or later they will break! This is especially
> true of small businesses, the major driver of employment in the U.S.
> Would YOU spend thousands or go into debt to start a new business
> if every 5-minutes someone else is telling you that everything will
> crash in the next 10-minutes? I don’t think so!
>
> Whether you’re a Republican or Democratic, whether you’re a capitalist
> or socialist, whether you’re a ying or a yang; we MUST ALL start
> to agree upon ONE THING and that is this short-term mentality and
> trading MUST END!
>
> STOP THE INSANITY NOW!
>
> Revised Tax Rules:
>
> 1. Capital gains under <6 months - 55% tax on capital gains
> 2. Capital gains 6 > 12 months - 45% tax on capital gains
> 3. Capital gains 1 > 2 years - 35% tax on capital gains
> 4. Capital gains 2 > 5 years - 18% tax on capital gains
> 5. Capital gains 5+ years - 5% tax on capital gains
> 6. Most critical of all — Institute a capital gains tax of 55% on
> ALL short sales not directly tied to a long buy by a licensed hedge
> fund. I'm tired of paying for the pure shorts 3rd vacation home.

Nov 01 09:59 PM

[bobdark:]

Maybe the title is a "freudian slip". I think "fail value" might be a more accurate assessment of the long-term market direction...

On Nov 01 10:00 AM Ricard wrote:

> Please change the title of this article. Not only is it misleading,
> it is somewhat offensive as well.

Nov 01 10:12 PM

[Andrew Butter:]

You are absolutely correct.

By my calculation the "Other Than Market Value" (OMV) of the S&P 500 is between 1,300 and 1,500 now (I'm not talking "Fair Value" which is a word that means many different things to many different people).

That's base on a valuation using International Valuation standards (which unfortunately no one uses in USA, which could explain why they keep going around in circles).

Of course that doesn't mean that OMV will likely be achieved at any time in the future since the US markets are going through the inevitable bust that you get after a bubble (seekingalpha.com/artic...), but from this particular point it's unlikely that there will be a reversal of more than 20% and even if there is it will be "V:".

The big danger is long-term interest rates going up, which is hard not to believe since the nominal supply is so much more than the demand, although the government is trying to contain that inevitability (and keep it's interest payments down), by buying short term Treasuries, which looks unsustainable.

Nov 02 02:33 AM

[Jeanne Klem...:]

EDITOR'S NOTE:

The typo in the headline has been fixed to read 'Fair Value'. Apologies for the mistake.

Nov 02 04:18 AM

[BlueOkie:]

Good luck picking the fair value of 30 stocks never mind just one. Averages are like putting your head in the oven and feet in the frig and saying "on average I feel good".

Nov 02 06:55 AM

[apppro:]

Thank you for proving my point!


On Nov 01 09:59 PM Jim Bob Jones wrote:

> So, let's all hold long term and give Wall street another chance
> to drain our piggy? I do'nt think so! Trade short term , follow the
> trend and protect your wealth unlike the so called knowledgeable
> banks and brokers.

Nov 02 06:57 AM

[Dan / The C...:]

IMHO, it seems to me that your assumption is that everyone is listening to, and reacting to these talking heads. Here's an idea, just turn them off!


On Nov 01 05:58 PM apppro wrote:

> <<So why would any reasonable investor want the government to have
> further sway in their financial well being?>>
>
> Our government screws everything up, that is for sure. However, we
> must deter or even stop all this short term trading and the mentality
> behind it. It produces NOTHING and saps the financial strength out
> of our economy. Without regulating anything, except hopefully our
> behavior, decreasing tax rates to promote long term investing and
> vice versa - we can only think that it would help reduce the insanity.
> The IRS got Capone, let them go after the other traders/traitors.
>
>
> On Nov 01 09:44 AM Walt17 wrote:

Nov 02 08:57 AM

[TwiceShy:]

"With interest rates near zero and government’s stimulus, the Dow is fairly valued. However, the economy might be substantial weaker ahead and last 8 months rally might be just based on cost-cutting or hope."

Those two statements seem inconsistent to me. My one question is: are the "earnings" upon which your valuation are based sustainable? Personally, I think not and, because of that, believe your analysis overstates the DJI's value. You seem to acknowledge that possibility in the second sentence above but didn't appear to take it into account for the purpose of your analysis.

Nov 02 09:19 AM

[logicalman:]

jim bob jones.....a lot have done exactly what you are saying, and most of them have lost their shirts....decide for yourself whether you are an INVESTOR or GAMBLER..if the former, do your homework and with an average iq. you will do well, if the latter, go to VEGAS, your chances will be much better there!!!


On Nov 01 09:59 PM Jim Bob Jones wrote:

> So, let's all hold long term and give Wall street another chance
> to drain our piggy? I do'nt think so! Trade short term , follow the
> trend and protect your wealth unlike the so called knowledgeable
> banks and brokers.

Nov 02 12:54 PM

[ebworthen:]

Fair Value?

Well...the P/E ratios have to be accurate, which they aren't.

If employment doesn't return, and tax revenues and company earnings don't improve (60-70% consumer driven economy) than P/E and DOW valuation goes out the window.

If government spending and liquidity continues, and the consumer and jobs don't recover, DOW valuation could revisit the 1930-1932 scenario where the market determined that valuations were 89% too high in October 1929 - it just took about two years of rallies and falls for true valuation to be determined.

We are at a moment in time, and it is all speculation. The only reality is are people working producing valued goods and services enough to grow the economy? It would appear we are still on the downward slope of deleveraging, debt, and employment.

Nov 02 03:01 PM

[DonFurio:]

wow, now this what other SA articles should look like. Something I don't say often on this site, nice work Author.

Nov 02 03:14 PM

[DonFurio:]

Is that really the shorts best defense these days, the charts from 1929-1932? Hahaha. I actually probably wouldn't disagree if you said that we may have another 5-7% correction, but let's be realistic here, things are very different today vs the 1930s. If you really are that confident that things will crash from here, why don't you put tons of money in out of the money put leaps. We'll see what happens in two years, but don't be crying if you lose everything because the SPY is at 1250.


On Nov 02 03:01 PM ebworthen wrote:

> Fair Value?
>
> Well...the P/E ratios have to be accurate, which they aren't.
>
> If employment doesn't return, and tax revenues and company earnings
> don't improve (60-70% consumer driven economy) than P/E and DOW valuation
> goes out the window.
>
> If government spending and liquidity continues, and the consumer
> and jobs don't recover, DOW valuation could revisit the 1930-1932
> scenario where the market determined that valuations were 89% too
> high in October 1929 - it just took about two years of rallies and
> falls for true valuation to be determined.
>
> We are at a moment in time, and it is all speculation. The only reality
> is are people working producing valued goods and services enough
> to grow the economy? It would appear we are still on the downward
> slope of deleveraging, debt, and employment.

Nov 02 03:26 PM

[Northstar10000:]

STOP THE INSANITY NOW
To have the tax rate this high on trading shows a complete lack of knowledge on how markets work. The 100 largest trading desks trading desks account for 75 percent of the volume on the NYSE.
the removal of short term liquidity would send the market and the country into free fall. In addition they can and would move their trading desks to any country offering a better deal. You think they are moving heavy equipment idiot. An office some computer terminals and a couple of desks and chairs can be set up in any country in less than 2 days. This type of mentality is why we are in this mess. Simpleton solutions offered by small minds filled with Hope and Change.

Nov 02 09:31 PM

[Northstar10000:]

This market will correct hard until the small fry gets scared again.
Then you will see another rally over 11000 before it tanks again just to fool the small fry yet again. It's a never ending cycle of taking from 90 percent of the folks and giving it to the 10 percent of pro traders.
Until you wise up this will never end. It has been going on since the
the NYSE was created. Until you recognize that government is not going to help you and you need to figure out the game yourself, nothing will change for you. the FEDS are never going to help you in any way, they are in on it wake up/////

Nov 02 09:39 PM

[Chris Chen:]

Mr. Hao Jin

I'm a reporter from China Times, and I got some questiones for you. If you OK for an interview please write me back: [e-mail]. Thanks.

Nov 03 11:01 AM

[apppro:]

Unfortunately there are many who feel that the gambling we have allowed to prosper in our markets is a legitimate way of adding liquidity into the market. BULL--IT!!!! The ones that think that all that trading and market manipulation is good for companies and our Nation as a whole, can only be the ones that fight tooth and nail every time someone wants to limit their insanity. Some even claim it's 'trickle down' economics. Really should rename that to 'pissing away' economics!

Just go 2 comments above and you'll see the real insanity. TAX these short-term option traders/traitors up the ying-yang and maybe they'll stop.


On Nov 02 12:54 PM logicalman wrote:

> jim bob jones.....a lot have done exactly what you are saying, and
> most of them have lost their shirts....decide for yourself whether
> you are an INVESTOR or GAMBLER..if the former, do your homework and
> with an average iq. you will do well, if the latter, go to VEGAS,
> your chances will be much better there!!!

Nov 03 05:42 PM