When the Dow Should Hit 50,000 and Why

Many of my own clients have come to me alarmed by the fact the Dow Jones industrial average surpassed a record high and is nearing 20,000. This got me to thinking, where should the Dow be valued, and why?

First, we have to define what makes ownership of equities go up in the first place. Equities are partial ownership shares of corporations. Corporations are in the business of making a profit. A typical measure of profitability is the forward-looking price-earnings ratio (P/E). For purposes of this hypothetical analysis, let's assume the long-term average P/E is 16.67 for Dow stocks. This means that for every $100 invested into the ownership of these corporations, your share of next year's profit will be 100/16.67, $6.00 or simply 6% of the company value for purposes of this analysis.

Assuming corporations earn 6% of their outstanding stock value in a year, we can also theoretically assume their underlying value is 6% more after a year due to the fact that the company has more equity available to benefit its shareholders than it did a year ago.

Companies typically grow their earnings over time. Assuming average growth of net earnings is 7% per year, we can compute that in a five-year period of time, the cumulative profits of a company will be about $40 for every $100 invested.

The Dow first eclipsed 1,000 44 years ago, in 1972. We know markets are volatile, but what happens when applying a 7% annual compounded increase to the Dow from 1972 to the past, present and beyond? And how did the actual Dow average compare with the 7% compounding figure at critical points in time? In 1981, the Dow was the most undervalued during the last 44 years, trading 52% below the 7% annual compounded trend line ("baseline calculation"). We can all agree that looking back, 1981 would have been a great time to invest as that year signaled the start of the greatest bull market in history.

Fast forward to the end of 1999, the market calculates to being the most overvalued in 44 years, trading at 85% over the baseline calculation. The subsequent crash nearly wiped out the entire 85% of frothy optimism priced into that market. At the end of 2007, again the market was substantially higher than the baseline calculation, indicating another great time to sell. By the close of 2008, the market achieved another great buying opportunity by closing 23% below the baseline calculation.

What about the market today? By starting at 1,000 in 1972 and compounding at 7% per year through 2016, the computed Dow would be at 19,600. In December of 2016, the Dow crossed that level, exactly as computed.

Extrapolating forward, we unearth more interesting results. The year 2020 marks where this math equation takes us to 25,000. In a mere 14 years, in 2030, the equation says the Dow would reach 50,000.

Stock market investing requires much more than simple math. But after reviewing this data, perhaps we can conclude that the simplest concepts combined with common sense could be our greatest ally when making solid investment decisions.

Disclosure: Madrona Financial Services, LLC, and its Investment Advisers cannot and do not guarantee the performance of any investment or insurance product. Past performance is not a guarantee of future results. Investors cannot invest directly into indexes.