How Fare Thee DJIA?

Adam Hamilton    October 26, 2001    5024 Words


“This is the time to buy stocks.  This is the time to recall the words of the late J.P. Morgan, that any man who is bearish on America will go broke.  Within a few days there is likely to be a bear panic rather than a bull panic.  Many of the low prices as a result of this hysterical selling are not likely to be reached again in many years.” – R.W. McNeal, prominent Wall Street analyst


In our surreal new Age of Terror, every financial market participant is eagerly monitoring the major US stock markets, anxious with both warm feelings of hope and cold qualms of dread.  With recent geopolitical events radically altering our collective perspectives on many aspects of life more rapidly in the last 60 days than perhaps in all the 25 years before, the sense of overwhelming uncertainty is pervasive.  As the foundations of normalcy are being shaken, event risk for every financial market remains extraordinarily high.


Of all the benchmark equity indices in the world, the undisputed king is the venerable Dow Jones Industrial Average.  For well over a century no market number has been eagerly watched by more investors around the world each day than the close of the DJIA.  While it is only comprised of 30 elite US companies’ stocks (and hence called the Dow 30), its paramount importance in the financial world really cannot be overstated.


The 30 blue-chip stocks in the Dow 30 were worth over $3,048b on the final trading day of September 2001.  By comparison, the 100 biggest and best companies trading on the NASDAQ, the NASDAQ 100, (excluding the two NASDAQ-listed companies included in the Dow 30, Microsoft and Intel) were only worth $879b on the same day.  The supreme importance of the Dow 30, both in absolute financial terms as well as in the psychological realms, utterly dwarfs every other stock index in the world, both domestic and international.


Since the bloody political statement by the followers of Mohammed last month, the gyrations of the Dow 30 have been carefully observed with even more interest than usual. 


Even though the NASDAQ crashed in March 2000 (see our essay “The Elusive NASDAQ Bottom”) and has spiraled lower trailing fire ever since, obliterating trillions of dollars of scarce capital, market analysts and investors could gaze with affection at the mighty unshakeable Dow 30 and feel the great bull market was still alive and kicking.


With the fortress Dow standing strong in the face of market and economic adversity, the case was often made that all is well and we are on the very verge of a new and exciting bull market in stocks.  As Mr. McNeal pointed out in our opening quote, who wants to be bearish on America?  It is indeed foolish to bet against the United States of America, the greatest nation that has ever existed.


America is a rare country founded on the unshakeable faith that the sovereign God of the Universe created mankind and endowed us with inalienable God-given rights that no government can usurp.  Although much has unfortunately changed for the worse since our Founding Fathers laid down the critical precepts for our wonderful 225-year-old experiment in liberty, the ideals of freedom still make America great today.


Only in a blessed land with ideals such as ours can men and women live without fear for their lives, secure in their God-given inalienable liberties, able to freely pursue private property.  This pursuit of private property that John Locke sagely wrote about, the very foundation of capitalism, is what has forged America’s economy into the strongest in the world.  


Even with America’s many problems, including an out-of-control federal government that is shamefully debasing our currency, gradually smothering our freedoms, and immorally taxing us at higher percentages than feudal serfs, it is indeed foolish to bet against America just as so many pundits proudly proclaimed after the terrorist atrocities.  Once the glorious seeds of freedom and liberty have been sown deep in the hearts of men, these ideals are not easily extinguished.


Yet, an absolutely critical distinction must be made between one’s feelings on America and one’s feelings on the US stock markets including the Dow 30.


Since capital is scarce and valuable, the very lifeblood of the fearless entrepreneurs who continually propel our economy and technology to fantastic new heights, it is our duty as patriotic Americans who love the timeless ideals on which our country was founded to carefully shepherd the capital with which we have been entrusted.


Good stewards of capital seek to preserve and enhance their wealth, not throw it away.  This is THE goal of investing, to preserve and enhance capital.  Like most things of true value in life, the basic wisdom for attaining this goal is so simple that even a child can understand it, yet to implement it in our own lives is very challenging.  The essential wisdom for investing can be summarized in four uncomplicated unambiguous words.  Buy Low Sell High.


There is literally a deluge of propaganda emerging from Wall Street these days carefully crafted to convince investors in US companies that NOW is a “great time to buy”.  Unfortunately, very little critical thought is advanced in the mainstream financial media outlining just what makes now such an opportune time to buy US stocks.


The American economy will not be made greater if investors are not able to Buy Low and therefore pay too much for their investments.  While it is a good thing to invest in American companies, it makes no sense to pay more than they are intrinsically worth.


As a little thought-exercise, imagine going down to your local automobile dealer and looking at a $40,000 sports utility vehicle.  If you decide you can’t live without it and write a $40k check to the dealer and drive off the lot in your shiny new urban assault vehicle, you are contributing to the US economy.  Even US Federal Reserve Governors aggressively press-home this point every chance they get.  If a new SUV is worth $40k to you, and you need a new vehicle, and you have the cash, why not buy it?


What if, however, this exact same SUV was selling for $200,000?  Is it patriotic or wise to buy something for far more than it’s worth?  Assume you have done your research on the SUV and you know darned well that your dealer is trying to gouge you.  If the SUV is only worth $40k, it makes no sense to pay more than that for the vehicle.  No one in their right mind would pay $200k for a vehicle worth $40k!


Spending more money on anything than what it is worth is not patriotic.  It is actually just plain foolish and inevitably leads to poverty and ruin.  Just as no one should be convinced to spend $200k to buy an SUV worth $40k, no one should pay more for a stock than what it is worth. 


If the Dow 30 is now fundamentally undervalued, then it is probably a great time to buy just as Wall Street proclaims. 


But if the Dow 30 is now overvalued, then it is the height of folly to recklessly deploy more capital there.  Rather than making America stronger and fueling innovation, mal-investment in overvalued stocks actually damages both the US economy and the investor making the poor decision.  We all want America to recover from this recession, but investing in overvalued companies will only prolong the misery, not bring about real economic growth.


In this essay we will take a look at the venerable Dow Jones Industrial Average and try to discern whether the Dow 30 is currently at an attractive “Buy Low” level as the legions of Wall Street bulls proclaim or a dangerous “Sell High” level as the almost-extinct Wall Street bears believe.


Please scroll back up to the top of this essay and re-read the opening quote from Mr. McNeal.  Of course, one’s love for country and one’s view on market valuation and direction have absolutely no relation, but Wall Street likes to falsely claim that patriotism is coupled with buying stocks regardless of their fundamentals.  We have all heard the incessant appeals to our love for America and our love for our fallen brothers and sisters in the ruthless terrorist attacks used to try to stir our consciences and convince us to send more money to Wall Street.


Only with the proper historical perspective does this deceptive equating of patriotism with investing begin to make sense.  The Wall Street establishment only sees huge profits when money is flowing into the US equity markets, not when it is flowing out.  Wall Street thrives on order-flow and capital-under-management and has no incentive to ever be bearish.  Wall Street is ALWAYS bullish on stocks and investors must never forget this critical historical truth.  Wall Street is right when there is a bull market but virtually always wrong when there is a bear market in stocks.


Make no mistake, the financial media and the Wall Street establishment exist solely to make money for themselves and be everlasting cheerleaders for the stock markets.  They seldom show any fleeting signs of pessimism until after the bloodiest of abyssal bear market bottoms only seen once every couple of decades or so.


It may startle you to learn that Mr. McNeal’s proud, patriotic, and bullish quote we opened with above is not from September 2001.  Actually it is from the New York Herald Tribune of October 30, 1929, one day after THE great stock market crash!  Of course, every investor today instantly knows it was insanity to be long US stocks in general following the October 1929 crash, yet Wall Street did not miss a beat in being unapologetically bullish all the way down to the dismal July 8, 1932 bottom in the Dow 30.


In order to try and help dispel this foolish notion that love-of-country and buying-stocks-no-matter-what are fully intertwined, we have dispersed fascinating quotes by men and entities of impeccable credentials from around the 1929 crash throughout this essay.  As you read these old quotes, digest our graphs, and read our current analysis of the Dow 30, realize that you cannot rely on the financial media and Wall Street for objective financial analysis.  REALIZE that each 1929-era quote below sounds EXACTLY like what we hear today in the mainstream financial media.


Only in the light of the wise perspective of market history are current market events interpretable.  Investors today would do well to study diligently and learn the hard lessons of financial market history.  If they refuse, then the same painful mistakes will be repeated over and over again.   This historical perspective, the Long View, is crucial when analyzing the Dow 30 or any other investment arena.


More popular sentiment from 1929 that proved to be disastrous advice for investors…


“While the crash only took place six months ago, I am convinced we have now passed through the worst, and with continued unity of effort we shall rapidly recover.  There has been no significant bank or industrial failure.  That danger too is safely behind us.” – Herbert Hoover, President of the United States of America, May 1, 1930



Just as the President in early 1930, well before the ultimate DJIA bottom, we cannot recall a single episode in history when the US political establishment expressed anything other than unbridled optimism about the US markets.  Don’t ever look to the political establishment for warnings about when the equity markets are dangerously overvalued!  Our first graph above is the very embodiment of optimistic sentiment.


Following its August 12, 1982 low of 777 (which ought to appeal to all you Vegas slots players out there!), the Dow 30 began its most spectacular bull market in history.  Interrupted briefly by the abrupt and frightening crash on October 19, 1987 (the DJIA lost 22.6% that ugly Black Monday, equivalent to a single-day loss of over 2100 points today), the Dow 30 soon catapulted to previously undreamed-of heights.


A classic speculative mania ensued, with the terminal rocket blow-off phase commencing in the mid-1990s as Bill Clinton ran for the 1996 Presidential elections.  Other than a scare in 1998 when the Russian government defaulted on its sovereign debt and the elite Long-Term Capital Management hedge fund had to be bailed-out by the Fed to prevent a systemic cascading-cross-default derivatives meltdown, the Dow 30 rocketed almost unimpeded to its ultimate all-time apex of 11723 achieved on January 14, 2000.


The magnificent years from 1982 to 2000 exhibited the largest rally the Dow Jones Industrial Average has ever seen.  Yet, with the benefit of the half-century Long-View strategic perspective offered in the graph above, nagging questions emerge.


Is this mega-bull-run sustainable?  Is that a monstrous top forming in the last couple years?  Did underlying cashflow and earnings fundamentals support such a galloping bull?  All these questions are hyper-important and should be diligently investigated by each investor before they decide to deploy their scarce and valuable capital in the venerable Dow 30.


To students of market history, the graph above unmistakably screams “BUBBLE!”  If there is one central lesson to be learned from studying centuries worth of market performance all over the globe, it is that exponential growth is always inherently unsustainable.  Periods of overvaluation and market extremes are inevitable in market manias, but they are always followed by deep, dark busts of equal magnitude to the preceding boom.


Any graph that has this type of parabolic exponential growth signature is a warning-sign for the wise investor.  Even in nature this truth holds.  If you were a naturalist studying the population of some type of animal within an eco-system, and a graph like the one above showed that population exploding, you would immediately intuitively conclude that this type of rapid growth is not sustainable over the long run.  Just as there is a finite limit to the biological carrying capacity of a given geographical area, there is also a limit to how much real wealth is available to continue pushing markets higher following a speculative mania blow-off phase.


If nothing else, the strategic big-picture Long View in the graph above should provide an initial clue to the prudent investor that the fundamentals and valuation of the Dow 30 ought to be carefully examined.  The Dow 30 hovering near the 10000 level is not as set-in-stone as it seems when one’s perspective is limited to only a year or two by the mainstream financial media and Wall Street.


Speaking of Wall Street, here is another 1929 quote right after the crash from a prestigious and well-known publication that is still unabashedly bullish to this very day…


“The Wall Street crash doesn’t mean that there will be any general or serious business depression.  For six years American business has been diverting a substantial part of its attention, its energies, and its resources on the speculative game.  Now that irrelevant, alien, and hazardous adventure is over.  Business has come home again, back to its job, providentially unscathed, sound in wind and limb, financially stronger than ever before.”Business Week, November 2, 1929



The then fledgling Business Week had already arrived at the conclusion mere weeks after the 1929 crash that speculative excesses had been wrung out of the system.  Yet, on the day before this issue was published, the Dow 30 closed at 274.  Investors who heeded Business Week’s advice would lose another 85% betting on the Dow 30 before its ultimate bottom of 41 in July 1932!  The timeless lesson?  Don’t trust the mainstream financial press during periods of rampant speculation and overvaluation!


In our current DJIA speculative mania, I have yet to hear a single prominent analyst on the payroll of a Wall Street firm issue a clear warning on the Dow 30’s unreal ascent or its stellar valuation.  The graph above zooms in on the last decade or so and tracks the spawning of a Dow Jones bubble in the midst of the great speculative mania in the US of the late 1990s.  The feeding-frenzy of speculative excess in recent years will be intently studied by students of markets for centuries to come as a definitive example of a speculative mania.


The Dow 30 in the graph above is superimposed with a yellow line.  This line is the hypothetical DJIA as if it had grown at a 7.5% annual rate throughout the 1990s, with an arbitrary starting point of the first trading day in 1990 when the DJIA closed at 2810.


Prudent investors who have made the crucial time investment to study the history of the markets realize that the average historical price earnings ratio of equities hovers around 13.5.  If you take the inverse of this critical average valuation, divide 1 by 13.5, you arrive at an average rate of return of roughly 7.5%.  We elaborated on this in more detail in our “US Equities: A Strategic Perspective” essay and also our recent “The Elusive NASDAQ Bottom” essay if you would like to dig deeper into this 7.5% average return concept.


As is quite evident above, the DJIA tracked this expected-return line beautifully until the mid-1990s, when it cast its fundamental chains asunder and bolted for the heavens.  The obvious “Why?” question is important but complex, and perhaps we will cover that in a future essay.  But, the important bit of information for investors to glean now is that the Dow 30 jumped its tracks and headed up into the great unknown in the mid-1990s.


In the shorter event horizon of this graph, the late 1998 Russian Debt Crisis/Long Term Capital Management debacle is much easier to discern.  As the red arrow shows, the immediate post-9/11 lows on the Dow 30 bounced well above the 1998 bottom of 7539 hit on August 31, 1998.  This presents a very grave problem for any who acknowledge that the DJIA is presently in a definite bearish trend.


True bear markets following major bubbles in history typically wipe out a decade or more of gains, not only a few years.  For reference, the Dow 30 began the 1990s at 2810.  If the Dow 30 is indeed in a bearish trajectory, as we explore further in our graphs below, it is a very hazardous postulation to assume that the ultimate bear market bottom will be well above the 1998 lows.  Yet another tantalizing clue that all may not be well in Dow-30 land contrary to the cacophony of Wall Street encouragement to “buy now because the worst is behind us”.


One final observation emerges about the graph above.  It is important to realize that booms and busts echo throughout market history like a classic sine wave. 


If you imagine a line with a trajectory similar to the yellow 7.5% return line in the graph above running through market history like a thread through time, that is the fundamental baseline.  This baseline perpetually rises because of the general progress of civilization as well as the incessant government printing of fiat currencies which puts more dollars into circulation leading to higher stock market prices among other consequences.


Around that modestly-sloped base line, actual market levels oscillate and meander like a gigantic multi-decade sine wave on an oscilloscope.  Great booms, such as we have witnessed in the Dow 30 since 1982, come along and push valuations to high extremes.  When the speculative mania inevitably exhausts itself and runs its course, a great bear market begins, but it ultimately pushes valuations far below the normal 13.5 P/E range down to 7 times earnings or so.  The bust drives equity index levels far below fair value and historical norms.


The knowledge of the macro-cycles of financial market history, endless waves of fanatical optimism followed by despairing pessimism, is essential for understanding the markets.  If you can visualize the Dow 30 as a blue sine wave slowly oscillating around a stable yellow average return and valuation line, you have a much better chance of avoiding getting trapped in the crushing bear cycle of the macro-sine wave as the excesses of the antecedent speculative mania are painfully unwound.


Investors lacking this crucial strategic perspective usually get slaughtered as market history marches relentlessly onward.  The Secretary of the Treasury after the Great Crash apparently had not studied market history and did not understand market cycles…


“I see nothing in the present situation that is either menacing or warrants pessimism.  I have every confidence that there will be a revival of activity in the spring and that during this coming year the country will make steady progress.” – Andrew Mellon, United States Secretary of the Treasury, December 31, 1929



It is amazing how closely Secretary Mellon’s comments echo popular mainstream financial sentiment today about the “spring recovery” widely prophesied for 2002.  Yet, provocatively, everyone on Wall Street seems to have conveniently forgotten the noisy “Second Half Recovery in 2001” rhetoric that was so popular during the first few months of 2001.  The more Wall Street changes, the more it stays the same!


Zooming in still further on the Dow 30 it becomes obvious that the sideways action since 1999, excruciating for both the bulls and the bears, looks remarkably like a major top.  The yellow 7.5% return line is the same offender from the previous graph, arbitrarily commencing on the first trading day of 1990.  The perpetual sine wave of valuation extremes echoing through market history is even still apparent with a short-term perspective of only about six years on the Dow 30.


The dashed-red lines mark the primary DJIA trend channel of the last couple years.  Note the downward slope of the trend channel.  Is this bullish?  Not for a minute, dear friends!  Multiple years of lower lows and lower highs do not paint a bullish picture and are definitely not a bullish omen for the venerable Dow Jones Industrial Average.


Not surprisingly, a series of lower lows and lower highs is exactly what we would expect in a bear market.  Yet, as we mentioned above, if one holds the belief that the Dow 30 is in a bear market, then it is pure foolishness to assume that the recent post-attack lows were the ultimate bottom, as they were far above the 1998 lows and bear markets typically wipe out far more than a few years worth of gains.  The deeper the prudent investor digs into the DJIA, the more foreboding the situation looks today.


Also note that the recent fantastic “recovery rally” since the post-9/11 lows has only taken the Dow 30 back to just above the bottom of its well-established trend channel, nowhere near a bullish technical breakout.  I bet you haven’t heard that on CNBC!


Extreme overvaluation, above the yellow 7.5% return line, is inevitably followed in history by extreme undervaluation, below the 7.5% return line.  If the DJIA is really in a bear market as its chart clearly indicates, and the unstoppable valuation sine wave of market history is finally nosing-over and heading down to unwind the speculative excesses of the preceding mania, the ultimate Dow bottom is far, far below current levels, probably hovering around the 4000 range.


Also on the bear-market front, it is important to realize that a bear market is defined as a 20% decline from the top.  As we noted above the all-time DJIA high was 11,723 in January 2000.  A bear market would officially begin at 80% of this summit, or 9378.  On the day before the terrorist attacks, the DJIA closed at 9606, within spitting-distance of official bear territory, and it was still falling.


Unfortunately, all this bearish evidence is zealously ignored by Wall Street in its over-the-top propaganda campaign designed to convince Americans that it is our “patriotic duty” to invest in overvalued Dow 30 stocks.  What utter hogwash!  Not surprisingly, little has changed since 1929 in the way the financial establishment always cheerleads for the equity markets and never warns investors of extreme overvaluation which can lead to financial doom…


“Stock prices have reached what looks like a permanently high plateau.  I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as they have predicted.  I expect to see the stock market a good deal higher within a few months.” – Dr. Irving Fisher, Professor of Economics at Yale University, one of the most important US economists of his day, October 17, 1929



When Dr. Fisher uttered those fateful words, the Dow 30 was trading at 342, not far from its all-time high for the era of 381 achieved on September 3, 1929.  Investors who listened to the famous economist’s advice talking about a “permanently high plateau” (read “New Era” in today’s hip vernacular) would ride the burning market down to a catastrophic 88% loss by the time the 1932 lows arrived. 


For the legions of bold investors out there today who proudly proclaim, “I invest for the long-term and have no fear”, it may be interesting to note that the Dow 30 did not return to the lofty level of 342 until July 22, 1954.  Talk about the long-term!  Investors who heeded Dr. Fisher’s considered expert advice in October 1929 got the chance to test the courage of their convictions for 25 years before they saw a single penny of capital gains!


The moral of the story?  Do your own due diligence and don’t place your financial future in the hands of any economist or market prognosticator, regardless of how famous they may be or how many accolades they have received.


Our final graph above cuts to the very heart of the issue of how the DJIA presently fares, valuations.  As we mentioned above in our SUV illustration, it is simply dumb to pay more for something than what it is worth, not patriotic.  Foolish investments delay the recovery and cloud America’s future for all of us.  The misallocation of capital does not make the US economy stronger, but far weaker and places it in great peril.


Over centuries, the average stock-market valuation has hovered around a price earnings ratio of 13.5, the inverse of the 7.5% return line.  We have published dozens of past essays available at discussing P/E ratios, the historical averages, and why valuation is of unsurpassed importance in investing.  After all, it is impossible to Buy Low and Sell High if one does not know how much an investment is worth!


This last graph, zooming in on less than two years of Dow 30 performance, shows the market-capitalization weighted-average P/E ratio of the Dow 30 in black and the market-capitalization weighted-average dividend yield of the Dow 30 in white as of the end of each quarter. 


Thankfully, as you can see, the Dow 30 valuations are gradually descending back towards reality even while the index trades sideways largely because earnings for the elite Dow 30 companies have generally been rising in the last couple years.


Yet, as is now common knowledge, the US economy was in dire shape even before the terrorist attacks (see our “The Pre-Attack Economy” essay) and is now far worse as already existing negative trends were accelerated by the geopolitical turmoil.  As the earnings of the Dow 30 companies begin to slide with the US economy, the “E” in the P/E ratio will wane and the valuations for the index will shoot higher.  This is a very ominous omen as bear market bottoms never occur historically at stellar high valuation extremes.


The Dow 30 will probably see its ultimate bottom when its P/E ratio plummets through the 13.5 average level and falls to 7.0 or so as extreme pessimism wipes out 18 years of extreme optimism and speculative excess.  Also, the DJIA will probably have a dividend yield equal to or exceeding bond yields once the ultimate bottom is reached.  In financial market history, both subnormal P/Es and high dividend yields competing with bonds are virtually always reached when the great sine wave of market valuation cycles spirals down to its ultimate bear-market trough.


The bottom line is the Dow 30 does not fare well in this strange post-bubble environment through which we all now sojourn.  The technical picture is dark, valuations remain extravagant, and the fundamentals are atrocious.  There is nothing patriotic about investing in a fundamentally overvalued Dow 30 and we strongly urge all investors to exercise extreme caution and do their own due diligence on the DJIA, ignoring Wall Street cheerleading propaganda blitzes.


If we examine current Dow 30 valuation levels based purely on current P/E ratios, fair value for the DJIA is probably around 4800 based on current aggressive earnings-reporting conventions.  Alas, however, since the Dow has been so overvalued for so long, it will probably plunge far lower approaching a P/E of half fair value around 7.0 before the ultimate bottom makes its appearance.  Obviously this kind of undervaluation based on current earnings is below 4000, not a happy prospect for one who is now long the Dow 30.


Looking at current dividend yields also implies an ultimate DJIA nadir of below 4000.  The index would have to fall a LONG way based on current dividends paid out by the Dow 30 companies to have a collective dividend yield approaching the market yields on bonds.


Any way we investigate and analyze the venerable Dow 30, once the warm-and-fuzzy Wall Street propaganda has been sliced away leaving the true fundamentals, it does not appear to fare well.  If history yet again proves to be a valid guide to how markets function, investors would do well to avoid being long the immensely overvalued Dow 30 stocks.


The true financial patriots will do their best to preserve and enhance their scarce capital through the aftermath of the US equity bubbles so we can ultimately rekindle the spectacular innovation and growth following the necessary yet painful financial process of the bubbles unwinding.  The more capital that prudent investors are able to preserve through these dangerous market times, the better off we will all be as a nation and the sooner the real bottoms will arrive so the true economic recovery process can begin.


“Hysteria has now disappeared from Wall Street.”The Times of London, November 2, 1929


Adam Hamilton, CPA     October 26, 2001     Subscribe at