E EC Einstein Not Newton More Helpful To Understand Equity Markets

In Measuring Equity Performance Picking a Reference Point is Crucial

The price performance of the DJII over the past five and a half years has been stellar. By comparison the performance of the economy has been has been dismal. From this arises worry among many commentators that the price of the DJII cannot continue to rise as Newton’s law of gravity must surely be invoked, even though physical laws have little to do with financial markets. Furthermore, Newton’s work has been long superseded by Einstein’s work on relativity. The importance of the latter is the point against which various measurements are calibrated. 

From the March 2009 low until the end of October 2014 the DJII is up 174% or 22.5% per annum. However, most of this improvement is just a recovery following the 54% decline from the previous peak of 14,165 in October 2007. From that point the price of the DJII is only up 27% or a much more modest 3.4% per annum.

2007 Peak based on Dividend-Discount Model

The choice of the 2007 peak is not arbitrary. It is based on the dividend-discount value of the DJII which stood at 14,196 which was very close to its price of 14,165. The subsequent drop in the DJII price was triggered by the ending, in sorrow and tears, of disastrous sub-prime loans, the collapse of earnings in the latter part of 2007, the collapse of Lehman and the ensuing financial meltdown.

Between 2007 and 2009 the DJII dividend was cut, but by only 24%, rather than being entirely wiped out like earnings. Interest rates fell simultaneously and pushed up the dividend-discount value of the DJII to a then record high while the DJII price fell as market participants wallowed in a mire of irrational pessimism.  

The collapse of earnings was probably the main contributing factor for aversion to equities.

The Seven Years following the Reference Point

Over the period from October 2007 until December 2014 the performance of the U.S. economy, the EPS and the dividends of the DJII have been in equilibrium with the price rise of the DJII.

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Tony Hayes CFA

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Mike Nelson 3 years ago Member's comment

Tony, how is the dividend discount value of the DJIA calculated?

Mike

Lalmani Tiwari 3 years ago Member's comment

The current problems started when Bush spent 6 trillion dollars on Iraq war. Obama's approach is better, more peaceful and diplomatic.

Tony Hayes CFA 3 years ago Author's comment

I do not apportion blame for the amount of debt or QE. I am merely trying to point out the consequences and their impact on the dividend discount value of the DJII that today is in excess of 32,000.

Over the past 35 years the price and the value of the DJII have had a correlation coefficient of 0.83. From this I suggest that price and value will move back into equilibrium and the pressure is on the price to move up.