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| That 70s show |
| Martin Hutchinson / Oct 16, 2009, 00:02 IST |
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Dow 10,000: Investors have rejoined the 10,000 Maniacs. The Dow Jones Industrial Average closed above that level on October 14. The venerable US stock benchmark first crossed that threshold in the dotcom bubble. It held higher for five years during the housing bubble. Long-term metrics suggest it is now in a new bubble. If the Great Depression or even the 1970s are a guide, it'll be back and forth across 10,000 for years.
The Dow first broke through 4,000 on February 22, 1995. That was the day Alan Greenspan, then Federal Reserve chairman, first hinted at a relaxation of monetary policy. At that time, the US economy was in its fourth year of expansion, and stock prices were 50 per cent above their peak before the 1987 crash.
So it's logical to peg 4,000 as an estimate for the Dow’s reasonable level at the time, in a period of modest economic expansion and optimism. Inflate that by the increase in nominal GDP in the intervening period — which should be related to company profits and valuations — and assume a 4 per cent annualised growth rate in nominal GDP in the third quarter this year, and the equivalent reasonable valuation today would be just north of 7,800.
Against that hypothetical level, the stock market is clearly in bubble mode, with the Dow up more than 50 per cent from its closing low of 6,594 on March 5. But then, the Fed has held interest rates around zero for a year, pumping money into the system.
Either rising inflation or excessive prices for commodities, particularly oil, will soon force the Fed to raise interest rates, most likely knocking stocks back. That’s assuming investors don’t pull back of their own accord first.
The Dow took 25 years to exceed the 1929 high that preceded the Great Depression. However, with a mere 4.2 per cent nominal growth rate in GDP built into the calculation, the Dow’s reasonable valuation passes 10,000 in 2015 – some 16 years after first touching that level. That would be the same length of time the Dow took from first topping 1,000 in 1966 to leaving that level firmly behind in 1982. Today’s low growth, low interest rates and rising commodity prices also seem rather 1970s. If so, that could be another hint that the Dow is again outrunning reality.
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