Fresh Market Records: Are Dow 20,000 and S&P 2,000 Next?

Stock Market

Source: http://www.flickr.com/photos/teegardin/

On Monday, the Dow Jones Industrial Average broke 16,000 for the first time ever, and the S&P 500 index hit 1,800, a 26 percent gain on the year and an all time nominal high (the S&P 500 index broke 2,000 in real terms in August of 2000). By the close of trading, the indexes retreated from their intradays highs, but the inevitable question of “what’s next?” had already taken root.

The answer is not necessarily binary — continued growth or total collapse — but it appears to be treated that way in most conversations, constrained between the bounds of bearish or bullish sentiment. After only a few hours on Monday after the markets broke those psychologically-significant benchmarks, if only briefly, it became clear that the consensus answer was bullish. For the week ended November 13, a majority 39.2 percent of respondents in the AAII Investor Sentiment Survey marked bullish, 33.3 percent market neutral, and 27.5 percent marked bearish. But why?

There are a couple of reasons. But first, for the record, in the AAII survey, the percentage of bullish marks declined while the percentage of bearish marks increased, suggesting that there may be some moderating of sentiment. The bullish long-term average for the survey is 39 percent, while the bearish long-term average is 30.5 percent.

So why are markets bullish? Accomodative monetary policy is surely one reason. The U.S. Federal Reserve has been purchasing agency mortgage-backed securities and long-term Treasuries at a pace of $85 billion per month for nearly a year now, and the low interest rate environment has been a boon for equities. The broader economy may be struggling to gain traction, but financial markets have been putting all that liquidity to good use.

But the Fed’s easy-money policy isn’t the only factor. Corporate earnings have been strong recently, and largely support the high price level of the S&P 500. As of June, the 12-month earnings per share of the S&P 500 were $91.20. At a price level of 1,800, that gives the index a price-to-earnings of about 19.7. This is higher than the long-term average of 15.50, but is not enormously out of whack. Any higher — as a result of accelerated price growth or decelerated earnings growth — and red flags may start going up.

What is somewhat concerning is the Shiller PE ratio, or the PE10, which uses rolling averages to smooth out volatility. Using this measure, the S&P has a PE10 of 25.16, much higher than the long-term average of 16.5, and not much below where the metric was just before the financial crisis. However, unlike during the dot-com era, when the PE10 hit a record high of 44.2, it is important to keep in mind that the 2008 financial crisis was not necessarily the result of a disparity in equity prices compared to their fundamentals. In order for the S&P 500 index to climb the 11.1 percent to a price level of 2,000 and maintain the current P/E, earnings would need to climb by about the same degree to $102.

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