To move up from the current 12,600 level to 20,000 by the summer of 2014, the Dow would need to rise about 16.5% each year or about 58% in a three-year period and in the past 25 years the Dow has risen by this much on at least 13 occasions. During those times, there was only one period of sustained annual gains, when the Dow rose an average of 26% from 1995 through 1999. The key question: what would it take to justify a three-year, steady, robust gain? It all comes down to corporate profits [and the extent to which] multiple investors are willing to assign [dollars] to these profits. [Let me explain.] Words: 761
So says David Sterman (www.StreetAuthority.com) in edited excerpts from an article* which Lorimer Wilson, editor of www.munKNEE.com (It’s all about Money!), has further edited ([ ]), abridged (…) and reformatted below for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement. Sterman goes on to say:
Right now, the S&P 500 trades for about 13 times projected 2011 profits of $103 a share and this is a reasonable number in light of very strong corporate profit margins in a time of real economic concerns. One could even argue the current multiple could expand to above the norm if the economic concerns receded and the economy started to grow at a steady 3.5% clip.
Let’s Make Some Assumptions and Do the Math
To be sure, corporate profit margins have peaked but if history is any guide, then 3.5% gross domestic product (GDP) growth would translate into 7% to 10% annual sales growth for many companies, accompanied by 15% profit growth. These are admittedly rough estimates and round numbers, but it would be in the ballpark. If profits indeed grew 15% annually, then the S&P 500’s aggregated earnings would reach $157 a share by the 2014.
Let’s also assume inflation remains largely in check and the Federal Reserve hikes rates by only 200 to 300 basis points from current levels. In this environment, investors might be willing to assign a slightly more robust multiple to the market, perhaps 15 times aggregated earnings. Apply this to the projected $157 a share, and the S&P 500 would rise to 2,500 — a roughly 75% gain during the next three years. Note, that when we looked at the prospect of the Dow hitting 20,000 before, we were talking about a 58% total gain. So Dow 20,000 is surely within reach by 2014 if the chips land the right way.
What Could Go Wrong?
1. Unemployment stays above 7%. Companies — especially those selling to consumers — would be hard-pressed to grow at a solid clip if unemployment remained at stubbornly high levels. The key swing factor in the economy involves hiring trends that would steadily reduce unemployment below 7%. This was the case in the middle of the 1990s. As companies finally expanded payrolls, consumer spending soared and the Dow posted a robust five-year run, as mentioned above.
2. Interest rates spike above 5%. In an ideal world, the economy grows at a moderate enough pace…to avoid bottleneck and pricing pressures but, in a worst-case scenario, the Fed’s extended balance sheet and the government’s ongoing borrowing needs could eventually lead to a spike in rates that would help find buyers for our debt. If inflation sharply moved up and the Fed needed to hike rates well past 5%, then there’d be no way investors could afford a slightly rich multiple for stocks. In such a scenario, “Dow 10,000” would be the buzzword.
The second half of 2011 is going to determine where we are likely to be in 2014 because the economy is showing both signs of life (as evidenced by recent robust data in capital goods spending) and signs of weakness (as seen by weekly jobless claims that can’t seem to fall below the all-important 400,000 level). One of these forces will eventually win out.
If the economy is indeed creating jobs at a decent clip later this year (consistently above 200,000 a month), then it may end up on a self-sustaining growth path — and the Dow would be on its way to 20,000.
Editor’s Note: The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
- Dow 20,000: the Latest in Hype, Happy Talk and Irrational Exuberance http://www.munknee.com/2011/06/dow-20000-the-latest-in-hype-happy-talk-and-irrational-exuberance/
- Could Dow 20,000 be Just Around the Corner? http://www.munknee.com/2011/05/could-dow-20000-be-just-around-the-corner/