Is the Dow Over-Valued?

This week the market is all gloom and doom. PIMCO's Bill Gross thinks that the Dow's fair value should be 7,000. GMO Chairman Jeremy Grantham also believes that the U.S. stock market is almost 25% above fair value.

I went through all of the DJIA component stocks (Dow 30) to find out what the fair value of the Dow really is.

The Dow Is Not a Bargain, but It's No Bubble Either

To calculate the DJIA, the sum of the prices of all 30 stocks is divided by the Dow Divisor, which is currently 0.132319125.

Name (Symbol) Price EPS (ttm) P/E EPS Est (next yr) Forward P/E
3M COMPANY (MMM) $73.6 $4.0 18 $4.8 15
ALCOA INC (AA) $12.4 -$2.3 n/a $0.6 23
AMER EXPRESS (AXP) $34.8 $1.2 30 $2.2 16
AT&T INC. (T) $25.7 $2.0 13 $2.2 11
BK OF AMERICA (BAC) $14.6 $0.1 166 $0.8 19
BOEING CO (BA) $47.8 -$0.1 n/a $4.4 11
CATERPILLAR (CAT) $55.1 $2.1 26 $2.7 21
CHEVRON CORP (CVX) $76.5 $8.1 9 $7.5 10
Cisco Systems (CSCO) $22.8 $1.1 22 $1.5 15
COCA COLA CO (KO) $53.3 $2.7 20 $3.4 16
DU PONT (DD) $31.8 $0.7 43 $2.2 14
EXXON MOBIL (XOM) $71.7 $6.2 12 $5.9 12
GEN ELECTRIC (GE) $14.3 $1.1 13 $0.9 16
HEWLETT PACK (HPQ) $47.5 $3.0 16 $4.3 11
HOME DEPOT (HD) $25.1 $1.4 18 $1.7 15
Intel Corporation (INTC) $19.1 $0.4 46 $1.5 13
IBM (IBM) $120.6 $9.7 12 $10.9 11
JOHNSON & JOH (JNJ) $59.1 $4.6 13 $4.9 12
JP MORGAN CHA (JPM) $41.8 $1.6 26 $3.2 13
KRAFT FOODS (KFT) $27.5 $2.1 13 $2.2 13
MCDONALDS (MCD) $58.6 $3.9 15 $4.4 13
MERCK CO (MRK) $30.9 $3.8 8 $3.4 9
Microsoft (MSFT) $27.7 $1.5 18 $2.1 14
PFIZER INC (PFE) $17.0 $1.2 14 $2.2 8
PROCTER GAMBLE (PG) $58.0 $4.3 14 $4.0 14
THE TRAVELERS (TRV) $49.8 $5.4 9 $5.7 9
UNITED TECH (UTX) $61.5 $4.2 15 $4.5 14
VERIZON COMMUN (VZ) $29.6 $2.0 15 $2.5 12
WAL MART (WMT) $49.7 $3.4 15 $3.9 13
WALT DISNEY (DIS) $27.4 $1.7 16 $1.9 15
TOTAL/AVERAGE $1,285.1 $81.0 16 $102.4 13

The Average P/E is 15.9. The Forward P/E is even lower. Historically, the market is viewed to be overvalued when P/E ratios move above 18.

The following metrics are scenario analyses, which list the potential Dow values based on different P/E and EPS:

P/E EPS (ttm) EPS Est. (current yr) EPS Est. (next yr)
Dow $81.0 $84.5 $102.4

14 8,570 8,936 10,835
16 9,794 10,213 12,383
18 11,019 11,489 13,931

The inverse of 14x earnings is a 7.1% yield, which is more than double the U.S.10 Year Treasure yield. Based on next year's estimated EPS and P/E of 14, I will not be surprised to see the Dow go as high as 10,835. But if you use trailing twelve months (ttm) EPS, the Dow could be 8,570.

This rally went "too far, too fast". The market might be overdue for a short-term, painful pullback for the following 3 reasons:

1. Recovery Driven By Government Spending

Fueled by government stimulus, the U.S. economy grew last quarter for the first time in more than a year. Aggressive stimulus debt must be repaid at some time. All government spending must be financed through some combination of taxation, borrowing, and inflation. Any government's ability to borrow and tax is limited. If massive and growing federal debt is to be paid off through higher taxes, the outcome could be a period of economic stagnation similar to Japan's "lost decade", according to an article in Financial Analysts Journal Sep/Oct 2009 issue.

2. Consumer Spending Is Down
The U.S. consumer has lost substantial value. The unemployment rate of 9.8% is the highest since June 1983 and payrolls have dropped for 21 consecutive months. No meaningful recovery can occur when incomes and jobs are falling at such rate.

The one sure thing for retailers is value. "Value has moved firmly from accessory to necessity. Retailers with a convincing value proposition will fare best during the year-end holidays."

3. Broken Financial System
Despite much improvement, conditions among U.S. financial institutions remain troubled and lots of them are effectively insolvent.

Protect Your Portfolio with Short ETFs

October is over, but that doesn't mean we won't get a surprise black Monday in November or December. The following are the top 4 short ETFs with net assets over $1 billion:

Fund Name Ticker Net Assets
UltraShort S&P500 ProShares (SDS) 3.44B
Short S&P500 ProShares (SH) 1.48B
Direxion Daily Financial Bear 3X Shares (FAZ) 1.18B
UltraShort QQQ ProShares (QID) 1.05B

These short ETFs offer a short-term hedging tool and a way to profit from declines. They can play a useful role in a conservative portfolio. They work fine for the short-term, but the perpetual compounding creates havoc over long period of time. In other words, they are for trading, not holding.

Conclusion

With interest rates near zero and government's stimulus, the Dow is fairly valued. However, the economy might be substantially weaker ahead and the last 8 months rally might be just based on cost-cutting or hope. If you are nervous about a potential correction, you might use short ETFs to insure your portfolio. Thus if the pullback does happen, you'll be well prepared.

Warren Buffett's Berkshire Hathaway (BRK-A) owns 9 Dow component stocks: AXP, BAC, GE, HD, JNJ, KFT, KO, PG and WMT. Those holdings account for around 50% of BRK-A's portfolio. This should give you a peace of mind if you are a disciplined long-term value investor.

Disclosure: I have long positions on MCD, SDS and WMT. All data is from Yahoo Finance as of Oct 30, 2009.

And be sure to check out our stock trading and ETF courses to learn how to profit from fundamental analysis such as this.