- A look at the DJIA from a valuation perspective will give us a good indication of future returns.
- I’ll also give a cyclical perspective on stocks by looking at their CAPE ratios.
- As well as explain how valuations usually contract and expand alongside earnings.
Two days ago, I discussed how valuations may be the biggest risk to stocks at this moment. Building on that, I want to go through the Dow Jones Industrial Average (DJIA) and discuss the valuations there.
The DJIA, unlike the S&P 500, is an arithmetic average weighted index and it is far less industrial than it was when it was formed in 1885. Nevertheless, it still gives a good impression of how the American economy is doing.
What I want to build on are valuations.
|Company||Ticker||Price||YTD change||PE RATIO||DIVIDEND|
|Johnson & Johnson||JNJ||128.82||-7.80%||330||2.61%|
|Procter & Gamble||PG||79.5||-13.47%||21.23||3.47%|
|Travelers Companies Inc||TRV||137.88||1.65%||18.85||2.09%|
General DJIA Overview
The stock with the lowest PE ratio is Verizon with 6.56, but that valuation will rise as future earnings come in. Pfizer also has a low PE ratio, but headwinds are expected there too.
The bulk of PE ratios fall between 15 and 30 while there are some exceptions like Visa at 41, Microsoft and Merck at 60, and with Coca-Cola and Caterpillar above 100 (forward PE is expected to be much lower). The average PE ratio is 45, but the median is 25 which implies a 4% return from investing in the DJIA now.
So investing in the DJIA is expected to give you a return of 4% over time, similar to what the S&P 500 offers with a dividend that is a little bit higher for the DJIA at 2.4% vs. 1.8%.
On the industrial perspective, given that the DJIA doesn’t include hot tech companies, we can say that it represents the new/old industry. Most of the companies have long histories and will probably be around for a long time, so it’s up to you to decide whether the 4% earnings yield—of which more than 50% goes to the dividend and much of it to buybacks—is something you are satisfied with now that the 10-year Treasury is approaching 3%.
You will get a better idea after we discuss a metric that will tell us even more about the DJIA, the CAPE ratio.
The DJIA’s CAPE Ratio
If a company is included in the DJIA, it means it offers stability, has some heritage, offers a dividend, operates positively, and is a significant player in the global business environment. These companies are regarded as blue chips
Blue chips give the impression of stability and that is why they are usually highly priced, but you shouldn’t pay too much for something, ever. Such companies are also under the influence of market cycles but have a strong history. Therefore, an even better measure of value is the cyclically adjusted price to earnings ratio (CAPE) which takes average 10-year earnings into account.
Given that the last recession was in 2009, the current earnings aren’t impacted by what might be cyclical influences. As we are in the late part of the economic cycle, the current earnings should be the highest earnings these companies can achieve in a cycle and therefore, we could expect lower long-term average earnings.
The average CAPE ratio for the DJIA is 29.55 which implies a long-term earnings yield of 3.38%.
|Company||Price||YTD change||PE RATIO||DIVIDEND||CAPE|
|Johnson & Johnson||128.82||-7.80%||330||2.61%||29.6206024373419|
|Procter & Gamble||79.5||-13.47%||21.23||3.47%||20.2857871906099|
|Travelers Companies Inc||137.88||1.65%||18.85||2.09%||18.0589390962672|
A growth stock like Visa is supposed to have a higher CAPE, but the key to successful investing here is to really see what the company will deliver in the future and whether it will be different from the past.
For example, Boeing’s CAPE is 55 which is extremely high. The PE is lower thanks to current strong earnings, but is also high at 25. If you are investing in or have invested in Boeing, the question you have to answer is whether the future will look more like the past or is there something that will change?
Further, the key to understanding investing through cycles is that as earnings expand, so do valuations. When earnings grow and are strong, valuations are sky high. However, when earnings contract, valuations contract too and that is the reason we have such big swings with stocks.
So as earnings grow, valuations grow disproportionately which isn’t logical especially with stable companies like those included in the DJIA. However, with a high degree of accuracy, we can say that the earnings will probably contract between 30% and 50% during the next recession and so will valuations just as was the case in 2008. When that happens, you can expect the DJIA index to be at least 50% lower.
There is nothing magical about that, it’s simply human nature to project the current into the future without elaborating on the fact that the future might be different.
Don’t be fooled by herd mentality and protect your wealth or at least have a strategy where you will be ready to take advantage of the time when the DJIA falls 50%. The expansion/contraction of earnings and consequently valuations is what usually kills the investor who thinks they are investing in the best of the best companies out there.