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Long-Term Returns To Expect From Dow Jones Industrial Average Stocks - October 11, 2008
United States Stock Markets as measured by the Dow Jones Industrial Average (DJIA) have recently suffered a major crash. The Dow at 8,451 has fallen about 40% from its high of one year ago. Much of this crash occurred in the past two weeks.
The earnings on the DJIA have fallen by 17% from $831 in 2007 to about $692 in the 12 months ended June 30, 2008 (which is the latest earnings data available). Additionally the P/E ratio has fallen 24% from 16.0 at the end of 2007 to 12.2 as of October 11, 2008. (A 17% drop in earnings combined with a 24% drop in the P/E explains the 40% drop in the Index).
The reason that the P/E has dropped is due to concern that earnings will decline further due to the financial crisis.
The average P/E of the Dow Jones Industrial Average, using year-end data, since 1926 has been 17.8. However, this is distorted upwards by a few years like 1982 when the P/E was 114 due to earnings that were near-zero due to some unusual losses by some major companies. If we eliminate several similar "outliers" a more representative average P/E is just over 15. Therefore the current P/E ratio of 12.2 is lower than normal.
This Article uses past trends to explore whether the Dow Jones Industrial Average is now under-valued or not and what return we might now expect over the long-term. (The short-term is basically unpredictable).
Demonstration of how a stock index rises with earnings:
Note that the graphs on this page all use logarithmic scales. Log scales are the ONLY way to properly show a trend in long-term data. On a log scale a constant percentage gain each year becomes a straight trend line. Analysis that uses a "normal" linear scale for long-term data will display an exponential curve with the data appearing to shoot to the moon.
As we would expect, a very strong relationship is seen above between the (blue) Dow index driven by the (red) Dow earnings. The width between the lines increases when the P/E ratio is high and narrows when the P/E ratio is lower. In general the slope of the two lines (which represents the growth) is roughly equal over the long-run.
As we are well aware, the Dow index line (blue) declined in 2000 and then reached reached a new peak in 2007 but as of October 11, 2008 has declined sharply. The decline around 2000 is not that dramatic when annual year-end data is used. We can see here that the crash around 1973 1974 was just as bad as the crash of 2000/2001. The 2008 crash has been just as bad as the crash of 2000/2001. none of these crashes is all that unusually in the context of the long-term. The 1929-1932 crash was much more severe than anything that has (so far) happened since.
Although the short-term is unpredictable we might expect the DOW line to advance in line with earnings growth in the long-term. Below, we will see that earnings growth is in turn tied to growth in Gross Domestic Product or GDP.
Demonstration of how stock index earnings relate to GDP:
This chart shows that earnings on the Dow stock index (red line) tend to grow at a rate similar to but slightly below the growth rate in GDP (blue line) in the long-term. (This is to be expected; earnings growth should track GDP per capita growth which lags GDP).
GDP growth is much more stable than earnings growth. Normally, U.S. GDP growth estimates by economists are in the range of 3% "real" with another 2% or so for inflation, for a total around 5%. We therefore should expect large cap stock indexes to normally rise roughly 5% per year (although with volatility). However in the next year the U.S. is expected to be in recession and so we might get no GDP growth or negative growth for the next year (possibly to then be recovered after the recession).
Note that estimates of earnings growth are usually made by stock analysts and often tend to be optimistic. While economists often project GDP growth at around 5%, stock analysts are more likely to suggest that earnings growth will be closer to 10%. Except when earnings have lagged GDP growth for a period, it is unrealistic to forecast earnings growth on a broad stock market index to exceed GDP growth.
Demonstration that GDP growth drove the stock index return:
This last graph is quite amazing. It was to be expected that the two lines would have similar slopes. The growth in the red DOW index line has been driven by the growth in the blue GDP line. It was a lucky coincidence that GDP in billions happened to equal the DOW index value around 1933. As might be expected the two lines then grew at similar rates and therefore ever after remained at least somewhat close together. In the 1960's the DOW index got above the GDP line. But this was followed by a long period where the DOW index went fairly flat as the DOW failed to keep up with GDP growth in the high-inflation years. The DOW then made up ground by racing up to "catch" and ultimately surpass the GDP line by the late 90's. Around 2000 the Dow index fell while GDP continued to grow. With the Dow line now below the GDP line we might forecast the Dow index to again track upwards with GDP growth. However, the graph shows that it is possible for the DOW to stay below the GDP line for an extended period.
On this graph we can also see that U.S. nominal (including inflation) GDP grew at a higher rate during the high inflation years starting in the 70's. But since then GDP growth has slowed in the recent lower inflation years. It may well slow further especially with a recession predicted for the next year.
Given a 5% average growth in nominal (after inflation) GDP, we can forecast that the Dow index (currently 8,451) should be around 13,766 in ten years (October 2018). However if the P/E at that time is 15 instead of the current 12.2, then the Dow would be about 16,925, which is a more realistic forecast sine the P/E is unlikely to stay at 12.2.
Conclusion
The level of the Dow Jones Industrial Average can be broken down to two factors. Earnings and the P/E ratio. Earnings can deviate widely from GDP growth in the short-term but over longer periods earnings tend to track GDP growth very closely, although it probably lags slightly in the long run. GDP growth tends to be quite steady at around 5% per year (in nominal dollars, including inflation). Periodic recessions reduce GDP growth but it tends to recover.
If GDP will grow at about 5% then we can expect an underlying growth in the DOW index of about 5% annually, although with significant volatility around that. Adding in dividends would provide a total average annual return of 7% to 8% (again with very significant volatility around that).
With the Dow P/E ratio now down at 12.2 we can can expect to get a one-time recovery in the DOW in the order of about 23% as the P/E ratio recovers to a more normal level of about 15. This should occur when confidence returns to the economy. (But meanwhile despair and the financial crisis could push the Dow lower).
A period such as now feels very pessimistic because markets have declined. However when the P/E ratio declines we are actually (from a long-term perspective) in a safer period since it will at some point recover to its long-term average of about 15.
Shawn Allen,CFA, CMA, MBA, P.Eng.
President, InvestorsFriend Inc.
October 11. 2008
www.investorsfriend.com
