From 1984 to 1999, the Dow Jones Industrial Average (DJIA) of stock prices increased from 1,212 to 11,497, a phenomenal rise of 850 percent in 15 years; average growth exceeded 16 percent per year. Long-term stock appreciation (11.5 percent per year across 50 years for the DJIA) has been so spectacular that stock investment was recently proposed as an alternative for some U.S. Social Security funds. The DJIA then declined and rested at 10,718 by the end of 2005, a negative return of 7 percent for the last six years (2000 to 2005). Perhaps Dow investment is not a promising alternative for Social Security. This article reviews the main propellants for the Dow’s appreciation and speculates on the Dow’s near future. Whither now Dow?
Dow Value: Three Economic Drivers
The DJIA reflects the cumulative market value of shares from 30 companies. In order to understand what drives the Dow, one needs a basic understanding of the financial components of stock value: earnings, earnings growth, and the investor’s required return. The three financial components, in turn, are driven by management action and by three economic conditions beyond the control of management: gross domestic product, inflation, and interest rates. Combined, economic conditions explain about 61 percent of the DJIA’s total value, while 39 percent of DJIA value resides with non-economic factors. (See Table 2.) The separate influences of these economic drivers are discussed below as they relate to the intrinsic valuation of stocks.
Intrinsic Stock Value
All assets, including stocks, are worth the future cash they will bring to their owner. Shareholders get dividends and a residual price when the stock is sold. Since the delayed receipt of cash has less value than cash in hand, future cash is discounted to the present at a risk-reflected opportunity cost of the buyer. Myron J. Gordon popularized stock valuation with the following formula:
Some firms pay no dividends. Their stock has value by accumulating earnings, i.e., a potential dividend. One may substitute earnings per share for dividends per share. The Gordon formula assumes a constant and perpetual growth rate after a finite future date. For any one firm, its perpetual earnings growth rate is continually re-estimated as economic and managerial circumstances change. The formula also assumes that the investor’s required return is related to the risk of each firm’s returns. Intrinsic stock value is thus affected by changing (a) earnings per share, (b) the expected growth of earnings, or (c) the investor’s required return relative to risk.
Investor Returns-Interest Rates-Intrinsic Value
A business’ value (and share price) may change as the investor’s required return changes, even with constant earnings. For example, if a buyer wants a 10 percent rate of return from a shoe store that generates a constant $6,000 per year (zero growth), the buyer should offer a maximum of $60,000 = $6,000 * (1 + 0) / (.10 – 0). If the required return declines as general interest rates recede (e.g., to 6 percent), the offer could rise to $100,000 = $6,000 / (.06-.0). Similarly, house prices in the U.S. have been driven upward during the 1980s, ’90s and early 2000s as mortgage rates have declined.
The same interest rate effects occur to the DJIA. Long-term U.S. Treasury rates provide a minimum for an investor’s required return with no default risk. Thirty-year Treasury yields (T30 in Table 1) dropped from 12.4 percent in 1984 to 5.0 percent by 2004. If a business earned $60,000 per year in 1984, it could be valued at $500,000 using a 12 percent, 30-year Treasury yield. By 2004, that same business could be valued at $1,200,000-a 140 percent rise (or 4.5 percent annual growth rate) resulting from the drop in interest rates, not from additional earnings. The DJIA has identically been affected. Debt cost has decreased while overall risk has shifted little. The Dow’s debt-equity ratio moved from 0.41 in 1984 to 0.86 by 2004; the Dow’s aggregate beta (relative stock return volatility) was a market neutral 0.99 as of 2004. Of the DJIA’s 11.5 percent average annual growth from 1984 to 2004, approximately 4.5 percent has been due to the decrease in long-term interest rates.
As with interest rate declines, consumer price inflation boosts the DJIA. Product prices rise. Costs rise. Earnings grow. The DJIA rises. Assume a pair of shoes presently sells for $100 and costs $60 from its manufacturer, the retailer garners a $40 (40 percent) gross profit. If general prices rise by 5 percent, the shoes can sell for $105, cost $63, and gross profit then rises to $42 (a 5 percent increase). Inflation creates earnings growth. It provides an opportunity to raise prices with little challenge. Costs may also rise. Dow companies are large and better able to mitigate cost increases by their monopsonistic position, i.e., ability to force cost increases to remain with smaller suppliers. Should costs rise, the firm can maintain profit growth by improving efficiencies, or by differentiating products, i.e., marketing “new” products at increased prices.
The Dow companies offer a cross section of services and products. At least 12 industry sectors are represented, such as financial institutions, basic manufacturing, technology, pharmaceutical, communications, etc. The continuity of Dow companies demonstrates their ability to adapt. From 1984 to 2004, the consumer price index (CPI) rose at a compound average of 3.1 percent per year. Actual earnings of Dow companies were significantly correlated to earnings propelled by the CPI and GDP (r=0.971) [See Table 1.]
Earnings-Gross Domestic Product-Intrinsic Value
Gross domestic product (GDP) is the cumulative value of all goods and services produced in the United States, deflated for price changes, i.e., the real volume of business activity. As the real volume of activity increases, each firm has a greater opportunity to sell its goods and services. The opportunity may differ between products, e.g., cell phone sales may increase faster than sales of leather shoes. A diversified product group, as represented by Dow firms, should exhibit the combined effects within the general economy. Thus, GDP growth should affect earnings growth in addition to the effects of inflation. From 1984 to 2004, GDP grew at a compound average of 3.2 percent per year.
Summary of Economic Drivers of the DJIA
Economic drivers have propelled the DJIA between 1984 and the end of 2004: 4.5 percent from interest rate declines, 3.1 percent earnings growth from consumer price inflation, and 3.2 percent earnings growth from gross domestic product expansion.
Table 1: Economic Drivers of the DJIA
Actual earnings per share correlate strongly with earnings projected by GDP and CPI (r = 0.971). The DJIA significantly correlates with actual earnings per share (r = 0.977). GDP and CPI should dominate earnings and value growth. These economic drivers have propelled the Dow at an average annual pace of 6.3 percent for the past 20 years. Long-term interest rates in the U.S. are at a historic low (2005) and should affect no further growth in the DJIA.
Economic Speculation-Near Term
Whither now Dow? Present Dow values may increase with U.S. GDP growth and CPI inflation. Dow values will likely be dampened by rising Treasury rates and dissipation of the non-economic value impounded during the 1990s. (See Graph 1.) The Dow offers limited opportunity.
GDP growth requires expanded consumption, domestic and/or foreign. Domestic consumption is constrained. Consumers now spend all that they earn, plus additional money that they borrow. In the past five years, consumers have propped up the economy by spending nearly $3.4 trillion of money borrowed on the equity of their homes. Little borrowing/spending capacity remains. Foreign trade growth continues to decline. Goods available from China and other foreign suppliers are less expensive than U.S. goods. U.S. GDP growth has no obvious stimulus.
Consumer prices are under pressure. Businesses compete for customers and profit. Energy cost increases have been largely absorbed through efficiency and productivity. Consumer prices should grow near their historic average.
Interest rates are depressed. Long-term Treasury rates are at a historic low. Their continued low level has been subsidized by foreign investors, especially those of China. Corporations are flush with cash with no obvious demand for capital expansion. GDP shows little growth potential. Continued low rates merely sustain the present level of the Dow, while increased rates would dampen the Dow.
The Federal Reserve has pushed short-term rates to a point of inversion: short-term rates now exceed long-term rates. Traditionally, such a situation has signaled a recession within the year. The increased cost of short-term borrowing discourages consumer demand, and the economy slows. In response, bond traders normally buy long-term bonds and drive down long-term yields in anticipation of the Federal Reserve’s cutting short-term rates to revive the economy.
Presently, U.S. consumer spending has not slowed and needs no stimulus from the Federal Reserve. Bond traders are in no rush to pay more for long-term bonds and produce even lower yields. In fact, just the opposite is true. Financial institutions need to borrow cheaply and lend at higher rates. Their profit opportunity has dissipated under present conditions. Financial firms account for one-fifth of the Standard & Poor’s 500-stock index’s market capitalization and a quarter of its total earnings. Furthermore, as earnings drop among the financial divisions of manufacturers and retailers, the aggregate earnings of Dow firms should decline. Such interest rate inversion presages poor performance for the DJIA, if not the economy.
DJIA Value: Economic, Management-Added, and Unexplained Portions
Using the basic Gordon model for intrinsic stock valuation, the DJIA was pared into three parts: the DJIA value affected by (1) the U.S. economy (2005’s earnings growing at the rate of GDP, priced at the CPI and discounted by returns based on Treasury yields); (2) management-added earnings above or below those from the economy; and (3) error and non-economic, unexplained elements. The following sections present a detailed discussion of calculations for Graph 1, followed by conclusions and implications.
Graph 1: DJIA Value Composition 1984 to 2004
Economic drivers were found to be significant propellants of the DJIA, averaging 61 percent of DJIA value over 20 years. Management added no value. Actual earnings have grown only at the rate of economic drivers. Unexplained factors and measurement error averaged 39 percent of the Dow’s value. (See Table 2 below.) The unexplained portion remains substantial. From 2001 to 2004, 65 percent of the DJIA is not explained by economic drivers.
U.S. Economy’s Effect on DJIA
From one year to the next, earnings and investor returns are driven by GDP, CPI, and Treasury rates. The DJIA effect of these economic drivers is computed into column three of Table 2 in the following manner:
Earnings growth is an estimate based on what is known (the present) and anticipated (next period). Since an investor does not have 20/20 foresight of the next period, the present period and the next period were averaged. This averaging process assumes that investors have some insight as to the direction of the U.S. economy while being anchored by recent experience. The “earnings” measure represents earnings before interest, taxes, depreciation and amortization per share (EBITDA), not basic earnings per share before extraordinary items. EBITDA has superior correlation with the DJIA (r-2= 0.95 for EBITDA versus r2= 0.84 for basic EPS). EBITDA measures about 90 percent of a firm’s actual cash provided from operating activities, while EPS measures only about 40 percent of cash flow.
The investor’s required return was approximated by adding premiums to the yield on a 30-year Treasury bond. The first premium is a 2 percent differential for the default risk of a Dow corporation compared to that of the U.S. Treasury. The second premium is the spread between the Treasury’s 30-year (T30) and 1-year (T1) notes. The spread enables investor requirements to expand and contract as the Treasury yield curve captures differential risks in the general economy. The spread is problematic with regard to valuation when 1-year Treasury rates exceed 30-year rates: the calculation may become negative or infinite. For two anomalous years, earnings were discounted at the rates of the succeeding year. On average, economy drivers explain 61 percent of the DJIA’s value. However, economy drivers represented only 35 percent of Dow value from 2001 to 2004.
Earnings may be affected by management’s actions as well as by economy factors. Present earnings may exceed (or fall short of) prior earnings projected by GDP and CPI.
The DJIA value of management-added earnings are computed:
In 8 of 21 years, the actual EBITDA exceeded projected EBITDA. Actual earnings were deficient in 13 out of 21 years. (See Table 1.) For the two decades ended in 2004, management created no earnings in excess of those projected by GDP and CPI, i.e., added no value to the DJIA. (See Table 2.)
Unexplained Value: Sentiment and Error
A significant portion of the DJIA’s value cannot be explained by economy-created or by management-created earnings. This unexplained residual may be due to measurement error or to the influence of non-economic factors. To determine if a portion of the unexplained value is associated with consumer sentiment, changes in the University of Michigan’s Consumer Sentiment Index (CSI) were correlated to changes in the unexplained residual value of the DJIA. CSI changes exhibited no significant correlation with changes in the DJIA’s residual value. The relationship was found to be the other way around. Changes in the DJIA residual show a one-year lead, inverse relationship to changes in consumer sentiment (r = -0.76; r2 = 0.58). One year after DJIA residual value increases, consumer sentiment decreases. Presumably, consumers sense the DJIA increase was not based on economic value. The CSI showed no contemporary or lead relationship to unexplained value.
In the 1980s, the unexplained portion of the DJIA averaged 19 percent of the Dow. During the 1990s, the unexplained portion rose to a 42 percent average of DJIA value. This is the period when U.S. Federal Reserve Chairman Alan Greenspan labeled share prices as “irrational exuberance.”
By the early 2000s, the average had risen further. The DJIA was essentially flat from 2000 to 2005. Economic value plateaued, dipped, and recovered. Now at its highest level since the early 1990s, the Dow has been sustained by unexplained factors.
Graph 1 illustrates that DJIA value was primarily driven by economic variables in the mid- and late 1980s. From 1991 onward, a large portion of DJIA value is unexplained. This condition has lingered. The Dow has resisted a return to economic fundamentals for nearly 15 years.
Table 2: Economic, Management-added, and Unexplained Values in the DJIA
During the 1980s, the DJIA was primarily propelled by economic drivers: GDP, CPI, and Treasury yield decreases. DJIA progression stalled when interest yields became inverted between 1989-1990. The DJIA expanded during the 1990s as Treasury rates continued to decline. The ’90s growth in DJIA was accompanied by an increasing portion of non-economic, unexplained value. Over 20 years, 61 percent of DJIA value has been shown to be economically based, while 39 percent is unexplained.
Economic based growth of the DJIA should average between 6 and 7 percent from GDP growth and CPI inflation. The DJIA will no longer grow as a result of declining interest rates. If long-term Treasury rates rise, they should dampen DJIA value. Management has added no earnings (and no DJIA value) in excess of the effects of GDP and CPI in the past 20 years.
In the past four years, some 65 percent of DJIA value has become unexplained and not linked to consumer sentiment. Whither now Dow? It appears to depend more on emotion than on economics.
Investing in market index funds has grown to trillions of dollars. Investors were drawn to these diversified funds as market indexes marched ever upward in the 80’s and 90’s. To a large degree, market indexes were driven by economic factors of the early 1980’s-declining interest rates, stable GDP, and low inflation.
Increases in DJIA valuation face a strong headwind. Management of large corporations has not shown an ability to earn significantly more than is offered by the economy, a 6.3 percent average. One cannot “rest assured” that the exuberance of the ’90’s will linger without increased economic performance. Near term, superior investment performance is most likely to be achieved through astute selection of a portfolio rather than through general indices such as a Standard & Poor’s 500 index fund.
“A Long-Term Perspective, DJIA 1920-2004,” Value Line Publishing (2005).
Financial Management: Theory and Practice (10E), Brigham and Ehrhardt, South western (2002), 389.
www.federalreserve.gov/releases/h15/data/a/tcm30y.txt (no longer accessible) retrieved November 2005.
Dow firm data from COMPUSTAT, Standard & Poor’s Research Insight, McGraw-Hill Companies, 2004.
The Wall Street Journal, 29 December 2005.
The Wall Street Journal, 30 December 2005.
“When Accrual Earnings Does Not Represent Cash Flow,” Western Region Conference, American Accounting Association, 2004, Newport Beach, CA.