Dividend Inc's  Instablog

Q: How do you calculate Dow Fair Value and why is 1.52 fair value?

A: Dow Theory is about long-term values as much as it is about technical analysis. For this reason, I have put in the right hand column some measures that I feel are necessary for gauging where the market is on a long term basis. One measure of long-term value is the Dow Fair Value indication. This measure tells us how close we are to a historical low in the value of the Dow Jones Industrial Average relative to the dividend yield of the same index.

To arrive at the fair value figure for the Industrials, I divide the P/E ratio by the dividend yield of the index. This data can be found in Barron's "Indexes P/Es and Yields" section. In the latest Barron's, the P/E for the Industrials is 16.38 while the dividend yield for the index is 2.80. Based on these two numbers, I arrive at a ratio of 5.85 (16.38/2.8=5.85). If, as I assert, the Dow is at fair value when the Industrials are at a ratio of 1.52, then the current level of the index is 385% above the historical fair value.

Where am I getting my data for this historical "fair value?" I am using the data from the Value Line Dow-Jones Long Term chart. This chart is free and contains the information necessary to calculate the fair value of the Industrials all the way back to 1920. Once you run the numbers you will see that almost anytime the fair value ratio is below 2 you're within reach of good values in the stock market. Whenever the Industrials are near 1.5 then you can buy stocks with little regard for values. Finally, when the Dow Industrials are below 1, you can buy stocks blindly with little regard for quality.

The following are the years when the Dow Industrials were below the ratio of 2 or less:

In every instance, if you had bought "for the long term" you would have never lost money in your investments. Obviously, had you selected the "lowest" ratio years you would have done even better. I'm not the creator of this method for looking at the market. However, I can say that it made enough of an impression for me to believe that it is worth carrying forward for the purpose of perspective on the market.

In my article on August 3, 2009, I addressed the question of whether the market would ever get to historical values again. I see no harm in repeating that, in order to have a perspective on the current market conditions, we must know the past. As time goes on, all the data from the past reverts to a mean. This allows us to make better decisions about the future. I do think that the historical norms will be visited by the indexes in the future, either by a market crash or by a long, drawn out secular bear market.