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The Meandering Dow
If you’ve had the feeling lately that the U.S. stock market, as measured by the Dow Jones Industrial Average, has been running in-place for about five years, you’re not the only one.
In May 2001, the DJIA traded over 11,250. As of the July 20, 2006 market close, the DJIA is trading around 10,928. In other words, five years have passed and the stock market, as measured by the DJIA, hasn’t gained a point: it’s actually declined. Further, after factoring-in inflation – dollars in 2006 are worth less than dollars in 2001 – the Dow’s losses are larger.
The nation is in the midst of an economic expansion – it has registered 4 years of above-trend GDP growth, the Fortune 1000 is just about to record another quarter of double-digit earnings growth, long-term interest rates are at relatively low levels, and the U.S. unemployment rate stands at 4.5%, but the DJIA hasn’t gained a point in five years. What’s going on here?
One Factor: Expectations
One theory argues that the issue, or at least Wall Street’s concern, relates to job creation, as well as to “the expectations game” that exists within the Dow’s average. [Expectations no doubt play a role in other stock market averages like the Nasdaq and S&P 500, but for illustrative purposes here, we’ll concentrate on the Dow.]
In May 2001, back during what we now know were the last months of the “Roaring 1990s” economic boom, the Dow at 11,250 was overvalued, most economists agree. Why was the Dow overvalued in May 2001? Wall Street expected the U.S. economy – which was in the midst of the longest peacetime expansion in U.S. history – to continue to grow at a solid rate, above 4% for the year. Because of this expectation, traders and investors bid the price of the Dow up over 11,000. In retrospect, the Dow was probably over-valued by about 15%, and probably should have traded around 9500 at that time.
Conversely, today, in late July 2006, the Dow is hovering around 11,000. Currently, there’s no consensus among economists concerning whether the Dow is slightly overvalued or undervalued. Many take the stance that the Dow is currently at fair-value at about 11,000, so for the sake of argument we’ll accept that calculation.
Hence, after adjusting for “the expectations game” the Dow has risen 1500 points since May 2001, or about 15.8% in five years. You say that 15.8% in five years is only about 3% per year – not very much – and hardly adequate to satisfy a stock investor’s risk/reward requirement, and you’re right. A 3% total annual return on equity is not nearly enough for most stock investors, and after factoring-in inflation, the rate of return in real terms is, again, close to zero.
Further, even if one assumed that the Dow in July 2006 is currently undervalued at 11,000 and should trade at a level, say, 10% higher given economic growth, to 12,100 that would still produce a total annual return on equity of about 5.5% since May 2001. That’s still a low return, historically speaking, for stock investors. The Dow should be trading at a higher level, but it isn’t: something else is holding it back. What could it be?
Another Factor: Job Creation
Economists are not united on this point but that second factor could be job creation. In 2005, the U.S. economy created 2M jobs. That sounds like a lot, but it’s not. The United States economy must create 150,000 jobs a month or 1.8M per year just to absorb new entrants to the workforce. Further, 2005’s job gains lagged far behind the historical norm: last year’s 2M job gain represents a gain of 1.5%, less than half the 3.5% average job growth rate for the same stage of the previous 4 business cycles that lasted as long, according to the Economic Policy Institute, a Washington, D.C.-based think tank.
Also, after adding 2006’s job gains, about 4M jobs have been created during the first 5 ½ years of the Bush Administration. In comparison, during the first 5 ½ years of the Clinton Administration, about 9M jobs had been created. Moreover, other job statistics [workforce participation, real wage gains for workers, private vs. public sector job creation] further underscore the sluggish job creation picture in the current economic expansion. In short, in the last four years while the U.S. economy has grown and Fortune 1000-company earnings have advanced at a healthy pace, job creation has lagged substantially.
So how does job creation, or the lack thereof, relate to the Dow Jones Industrial Average? Here again, economists are not united on the question. Many economists argue that traders and investors need to see not only evidence of sustained consumer demand, such as monthly reports on purchases of durable goods like refrigerators and washing machines, which provides information about consumption today, but “broadened consumer demand,” which provides insights into the size of consumption tomorrow. Hence, for traders and investors, job creation - and the broadened consumption it implies for the future - is perhaps the second most important statistic after corporate earnings reports, these economists argue. Continued, robust job creation signals to traders that demand for goods and services is likely to extend well into the future. And in Wall Street’s time-reference terms, “well into the future” means at least the next 6-9 months, and these traders and investors, accordingly, will bid the price of the Dow up. Conversely, continued sluggish job growth or low job growth creates doubt regarding future demand for goods and services, causing traders to reduce their investment time-frame, or stay out of the market entirely, and the Dow meanders.
To be sure, globalization, emerging market economic growth rates, the price of crude oil, interest rates, and geopolitical concerns are all factors that influence the Dow’s level, as well, but until the great American job machine kicks into high gear, look for the Dow to continue to meander.