With the Dow Jones Industrial Average below 7,000—at 6,763—the US stock market is well below its early-1995 level, adjusted for changes in nominal GDP. That suggests it’s cheap—if growth prospects are as good as they were back then. The risk, however, is that too much fiscal and budgetary stimulus will bring on growth-stultifying inflation.
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The Dow Jones Industrial Index closed at 6,763 on 2 March, down 52% from its 2007 high. The Standard and Poor’s 500 share index closed at 700.82, down 55% from its 2007 high.
Earnings on the Standard and Poor’s (S&Ps) 500 Index are expected to be negative for the fourth quarter of 2008, for the first time since such calculations began in 1936, and are expected to be below $40 per share for the whole of 2008.
S&Ps currently estimates operating earnings on the S&P 500 of $48.10 and “as reported” earnings of $32.41 for 2009.
On 5 December, 1996, the S&Ps 500 Index closed at 744.38. That evening, US Federal Reserve chairman Alan Greenspan decried the market’s “irrational exuberance”. At its 2 March close of 700.82 S&P 500, the market is exuberant no more.
It is not, however, exceptionally low. Greenspan announced a new easier monetary policy to Congress on 23 February 1995, the day the Dow Jones average, which had been generally rising since 1990, first reached 4,000. Adjusting for the 95% increase in nominal GDP since that time would give an equivalent Dow level today of around 7,800. That suggests current levels are somewhat below their long-term trend, and that the 1996-2007 period represented a lengthy bubble.
S&Ps currently projects 2009 earnings on S&P of $48.10. Over the 20-year period to 2008, the index traded at an average of 19.4 times earnings. That would give a current value of 933.14. That 20-year period includes the 12-year bubble; taking a longer-term average of around 15 times earnings gives a valuation of 721.5, again, just slightly above the current level.
So, based on 1995 prices and long-term earnings considerations, the market is just below a middling valuation.
That assumes US growth and earnings prospects are as good today as they were in 1995. That’s where doubts creep in.
If the exceptional monetary stimulus since September produces inflation, or the unprecedentedly large budget deficits in fiscal years 2009 and 2010 “crowd out” private investment, then growth and earnings prospects for the next few years would be below average. In that event, the market as it stands today would be overvalued. Bailouts and stimulus can thus produce long-term uncertainty as well as short-term uplift.