It seems as though you can’t turn on Bloomberg or CNBC without hearing someone mention that the Dow Jones Industrial Average is crossing the 20,000 point mark. Before 2017 this threshold has never been crossed and it represents a psychological level in most investors’ minds. Some experts believe that the markets shouldn’t be where they are today and that they’re due for a correction. Other experts believe this is just the start of another upward trend over the next few months. My thought on the matter is this. What’s the big deal anyways?
What is the Dow?
The Dow Jones Industrial Average is a price weighted stock index that represents a subset of stocks sold on the New York Stock Exchange and the NASDAQ. The Dow was created by Charles Dow all the way back in 1896 and is the second oldest stock index. It is composed of 30 large, publicly traded companies (industrial and non-industrial). Many people reference the Dow Index when discussing how the markets are doing and, just today, the index hit an intraday high of 20,082.
Don’t Markets Tend to Go Up?
Would you not agree that historically the markets tend to increase over long periods of time? Let’s look at an extremely simple table showing the values of the Dow over the last 30 years, showing only data points every ten years.
Like I said – a very simple table. This data was gathered using yahoo finance and shows the DJIA closing prices on the dates listed (adjusted for dividends and splits). As you can see, the Dow has increased considerably each decade. What the data doesn’t show are the various ups and downs the markets have experienced. The table doesn’t show the crests and troughs of the unemployment rates or the various periods of political and economic instability which can heavily influence markets. But what it does show, again, is that over long periods of time the markets have increased, without fail, decade-over-decade since 1987. Using the logic above that markets will increase over time, would it not be realistic then to think that the markets should ALWAYS be at an all-time high unless a recession is absolutely imminent?
When thinking about the economy and investments I like to use analogies to try to reason with myself. It’s a known fact that as people age, especially elderly folks, that their health declines (I won’t show any tables for this, hopefully you just believe me). Think about when you were growing up and you’d visit your grandparents. If you saw them often you probably didn’t realize any changes in their health unless they were fighting a cold or perhaps they had the flu. If you were to see them only once a year though you may notice small decreases in their health. You probably wouldn’t tell your grandmother that she looked to be in worse health than she was in a prior year. And you most certainly wouldn’t do this annually. If you did this to your grandma every single year then she would likely tell your parents to just leave you at home the next time they visit. Thinking about this would it seem unreasonable then to say that as you get older it’s simply expected that your health will slowly decline? What if you were given a range of years – from the present year through the last 30 years and you were asked to bet on which year your grandmother would be in the worst shape. Odds are you would bet this year, since this year would be most realistically the year in which she’s is in the worst shape.
This example is how I relate to the current market levels. If I had to pick just one day throughout history in which the markets would be their highest which day would I choose? I’d choose today since I know that over long periods of time the markets increase and that I want to simply choose the option which gives me the highest probability of winning. Are the markets higher than they were a year ago? Sure. Should they not be that high though? That’s hard to say. Experts recommend not trying to time the markets. Instead they recommend staying invested for long periods of time, assuming your time horizon is at least several years out. Instead of trying to time the markets an investor could use a buy-and-hold strategy or they could also implement dollar cost averaging. One simple way to use dollar cost averaging to avoid trying to time the market is by using a DRIP.
In the earlier Dow Jones example we looked at only a few data points. What happens if we expand on that? If instead of only looking at one value per decade let’s look at one value year. The data is below.
As you can see there is quite a bit more volatility but we still see the upward trend over time. Out of 30 years there were six years with negative returns, three years the index was relatively flat, and 21 years had positive gains. If we take this several steps further and look at it on a day-by-day basis the results are much more even. Out of 7,556 days there were 4,014 positive days, or 53%, and 3,542 negative return days, or 47%. This simply means that it’s very difficult to predict day to day movements within the markets but much easier to predict decade-over-decade changes (100% positive gains) or year-over-year changes (70% positive gains).
In a perfect world an investor could use fundamental analysis to determine whether the markets are fairly priced. In reality though the markets are driven by many factors. Some of them are logical while others are illogical. Nothing is off limits when it comes to how analysts will make their predictions. Analysts will, understandably, look at unemployment rates, gross domestic product, future earnings’ potential of companies, consumer sentiment, and many other factors to try to make predictions. With that being said it should be noted that the unemployment rates are near the lowest they’ve been in the last 10 years and that the GDP has risen in 64 of the last 65 years.
This post isn’t about making a prediction or trying to get people to invest one way or another. It’s simply trying to give you something to think about regarding the markets and to try to have you think of investing as more of a long term endeavor. Most people who think the markets are overvalued are saying so due to the recent run-up in prices as well as the high p/e ratio relative to historical values for the markets. The problem with simply stating that the p/e ratio is high doesn’t take into account the increased likelihood of higher inflation in the United States. Inflation is now expected to increase at a much faster pace than just a few months ago as the President promises to decrease taxes and increase individuals’ disposable income. As inflation increases look for corporate earnings to skyrocket, and when that happens there will be a natural decrease in the p/e (since earnings are the denominator in the formula) ratio, assuming the price of the index stays flat. This will be coupled with an increase in the amount of dividends paid out by companies. If this happens and the p/e ratio falls will the markets then be undervalued? Who’s to say.
Perhaps in a decade I can post this exact same blog, although I may have to alter the headline to read “40K” rather than “20K.”