Dow 20,000: How It Could Happen

May 16, 2011 12:50 PM ET4 Comments
John Tobey, CFA profile picture
John Tobey, CFA
1.25K Followers

Most first quarter 2011 earnings reports are in and the news is good. Over three-quarters exceeded expectations. Moreover, the results showed a desirable combination of growing revenues, profitability and cash flow. Profit margins are being maintained by cost control, improved productivity and operating leverage. This combination of factors helped push analysts' 2011 earnings expectations up 4.7% for the Dow Jones Industrial Average (DJIA).

Importantly for investors, stock prices rose less than forecast earnings, making valuations more attractive. The recent focus on "exciting" investments (e.g., silver) has caused U.S. stocks basically to tread water.

Here is the picture - first of estimated earnings, then of price/earnings (P/E) ratios …

DJIA estimated EPS
(Click to enlarge)

DJIA price/earnings ratios
(Click to enlarge)

No signs of speculation

An ongoing worry is that the stock market has risen too high and is due to drop. One way to answer that belief is to focus on the fundamentals, above. Another is to look at what is not present that would support the worry: Speculation.

Here are some key areas that illustrate the lack of stock market fever.

The doubling since March 2009 is based on fundamentals. It's true the market is up that much. However, the reversal of the early-2009 emotional drop and the subsequent fundamental improvement produced the increase, not speculation.

Note: In spite of Ben Bernanke's claim that the Fed's easy money policy helped the U.S. stock market, the valuations tell a different story. Fundamentals provided the push. Therefore, investor worry that the end of QE2 will cause a stock market drop is unfounded.

Every positive can be countered by a negative. This truism is visible in the media every day. A good example is in this week's Barron's – "The Yes-Yes Stock Market." This point/counterpoint situation is the description of a healthy market, not a speculative one.

Valuations are sound. Compared to typical bull markets accompanied by investor enthusiasm, today's stock market valuations are conservative. In the past, the average P/E ratio (using 2011's estimated earnings) could easily be 15. Today, that would put the DJIA at 15,000 – about 20% above today's level. Add in high optimism (the kind we've seen in other investments recently) and a 20 P/E ratio would be possible (the DJIA would be 20,000 – 60% higher).

DJIA at different PE levels
(Click to enlarge)

Clearly, a 20 P/E would be a time to be wary. However, today's DJIA level of 12,600 (12.6 P/E ratio) is not something to worry about – it's something to take advantage of.

So … The first quarter earnings reports provided continuing good news for the stock market. With forecasts of more to come, U.S. stocks offer an excellent investment opportunity. Moreover, with alternative investment speculation suffering, the timing could be good. (See "Stock Market Has Become a 2011 Performance Leader")

Disclosure: Positions: Long U.S. stocks and U.S. stock funds

This article was written by

John Tobey, CFA profile picture
1.25K Followers
I am the founder and editor of Investment Directions. My career has been managing and consulting to multi-billion dollar funds. Using the widely accepted “multi-manager” approach, I have worked with top investment managers throughout the country, gaining a high level of expertise. My career has spanned many market environments, and I have hands-on experience searching out opportunities and avoiding risks in all of them. I now devote my time to Investment Directions, with the goal of helping investors further their understanding and improve their investing skills. I am currently serving on: The AAUW Investment Advisers Committee and The City of Vista Investment Advisory Committee.
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