30 Jan 2017

The Dow at 20,000: What's All That About?

Luis Viceira
Photo: Russ Campbell

It took more than a century for the Dow Jones Industrial Average, which tracks thirty selected blue chip stocks, to hit 20,000, but it finally happened last Wednesday – a milestone marked by banner headlines and happy investors. In a recent conversation in his Morgan Hall office, Harvard Business School finance professor Luis Viceira, an expert on investment management and capital markets, offered his views on how this happened, what it means, and how high the Dow may go in the future.

Last week the Dow closed above 20,000 for the first time since its creation in 1896. What do you see as some of key factors that led to this?

Luis Viceira:The Dow is an index that has traditionally included the largest companies traded in the US stock market. Its growth since its inception reflects the growth and profitability of these companies and more generally the success of the US economy in the last hundred-plus years. There was no specific event that brought the Dow over the 20,000 mark last week. Markets exhibit a fairly large degree of short-term volatility, so once you get close to 20,000, normal daily market volatility would be enough to bring the index over the hump – and there has been enough volatility in recent days to bring that number slightly below 20,000 again. But I think what brought us all the way to 20,000 from about 18,000 just three months ago reflects the impact of the election of Donald Trump on the markets, an effect that involves four things.

One is that the markets expect strong deregulation, and that impacts every other sector that is highly regulated in the economy. So you saw the rising stock prices of financials, for example, as well as energy stocks.

The second effect comes from promises to reduce tax rates and corporate tax rates in particular, which means that profits are going to be higher. As a result, stockholders will get a bigger share of the pie. That raises stock prices all over the place.

A related effect is the issue of repatriating profits from abroad – with companies bringing back to the United States the cash they have been keeping in other countries, because repatriation is expensive from a tax perspective. The expectation is that this administration wants that to happen and will do so by allowing this to happen at a reduced tax rate. So again, we have a tax effect impacting stock prices positively. And to the extent that taxes do not limit where companies keep their cash holdings and that companies have better uses for their cash here in the US than abroad, this can also have a positive effect on stock valuations.

A third effect comes from the new administration’s promises to raise the spending on infrastructure. That has a positive impact on the price of stock of companies that will benefit from this spending, such as those that specialize in materials, for example.

That said, there are some opposite forces at work, too. I think it is fair to say that President Trump’s electoral promises and statements during the campaign have also raised a sense of uncertainty and ambiguity on several fronts. One of them that I think could result in a significant drawback is trade. Since the companies in the Dow are global, they could be negatively affected if we end up in a series of trade wars, especially with the United States’ main trading partners--the European Union, China, and Japan.

So far, however, the markets don’t seem very concerned about that, perhaps because the power of the president has limitations or perhaps because the markets think that this where the new administration might be taking a tough stance to renegotiate trade deals but does not really intend to disrupt the status quo of global trade and the free movement of capital, both of which have benefited this country immensely. Free trade has been in the DNA of the Republican Party for a long time, and for good reason. I would expect Republicans in the House and Senate to resist any populist measures that threaten the ability of corporations to compete globally and hurt the US economy in the long run.

Let’s talk about the number 20,000. Is that a meaningful number or simply a big round one with psychological impact?

LV:There’s certainly a symbolic vibe when the Dow gets to 20,000-- something to celebrate to the extent that it reflects the American economy’s long history of growth, profitability, and success. For the professional and institutional investors who today do the bulk of the buying and selling in the capital markets, it’s perhaps simply a good time to celebrate the success story that it is the US economy and US capital markets and to reflect on what it took to get to this point in our history.

For so-called retail investors, individuals who buy and sell a relatively small number of shares for their own account but who are not paying attention to the market all the time, the Dow at 20,000 is clearly an event that does catch their attention. The news around it will make them turn their attention to the markets and their portfolios and reevaluate their investments. Beyond cheering, they may also wonder whether this is a frothy market that might go downhill or a bull market that will continue to run strong. If they conclude it is the first, they may opt for selling their shares. Would that have a big downside impact on the markets? Probably not, given the preponderance of professionally managed money in the markets. Even retail money is invested today mainly through professionally managed vehicles such as mutual funds, 401k plans, and index funds, and retail investors tend to be much less prone to panic when they invest that way. To that we need to add the enormous growth in index investing since the turn of the century.

A factor that makes me optimistic about this market is that stock prices on the whole do not seem as clearly disengaged from fundamentals as they did in 1999, when the Dow reached 10,000 for the first time. Then there was a sense that we might be in a bubble since the only way to reconcile stock valuations with fundamentals was to believe that the US economy would grow almost forever at rates never seen before or that investors had stopped caring altogether about risk and market volatility. Lots of investors were saying that this time was different, that we were in a new world where high tech ruled. We got to hear outlandish claims that stocks were riskless. The Dow did climb past 11,000 in the next few months but then went nowhere before crashing in September of 2001 and then again in 2002, coming all the way down to 7,500. And of course we all remember the subsequent bull market and how badly it ended in the fall of 2008 after the whole financial system almost collapsed. I don’t have a crystal ball, but as I’ve said, current valuations of the big blue chip companies in the Dow do not look excessively rich relative to fundamentals.

Does reaching 20,000 on the Dow really say something about the state of the US economy?

LV: By comparing where the index is now to where it was at some point before, it tells you that in the long run, the economy has done well. For example, we have had an amazing bull market since March 2009, when the Dow traded at 6,630 or so. The US economy is in its longest economic expansion in history, albeit at growth rates that look anemic compared to other times in history. So that certainly reflects a huge success story, at least when it comes to stock prices and the value of large American companies. With unemployment at 4.6 percent, we have a number that is extremely positive despite the fact that, as the election result made clear, there are also pockets of long-term unemployment in several parts of the country, groups of fellow citizens who have suffered the consequences of globalization. That’s certainly a cause for concern and something about which we should do something. But with one of the longest recoveries in history upon us, the US economy as a whole appears to still be in a growth mode. Our biggest challenge today is persistently weak productivity growth, which, as the Harvard Business School US Competitiveness Project has pointed out, has an adverse effect on wages and competitiveness.

Of course, there is always a catalyst for a sudden downturn on markets. Today, a sudden and disorderly reversal of globalization could be one such catalyst that could bring growth to a halt and send markets down. Instability in other parts of the world, such as a problematic breakup of the eurozone, could be another. With so many boomers retiring in the next few years, that is something else to worry about.

The Dow, which was created by the founder of the Wall Street Journal, gets lots of attention and publicity, but comprises only a small number of companies. Should we be focusing on broader indexes such as the Standard & Poor’s 500 or the Wilshire 5000?

LV: For investors who want broad exposure to the market, the Dow will not give you that. That’s why the portfolios of most index funds are tied to indexes that reflect the market more broadly. When you focus just on very large blue chip companies, you are leaving out three big chunks of the market – midsize and smaller companies as well as high-tech and high-growth enterprises that might be the next Google. Nevertheless, when you look at how the movements in the Dow correlate with broader indexes, the correlations tend to be very high, so the ups and downs of the Dow actually do tend to reflect those of the broader market. Still, it makes sense that most investors aren’t interested in a strategy that invests only in the Dow. They want a broader exposure. After all, they would like to be able to invest in the next Apple before it becomes a great success.

Do you think there’s a Dow 30,000 sometime in the future?

LV: I think that we will, just as I also think it is foolish to believe that this will be a straight line up. Stock returns have historically been about five percent per year on average, which would make you think that Dow 30,000 is just nine years away. But we can’t forget that the market has significant short-run volatility, and that there are long stretches of time when the market has gone nowhere or even worse, south. There is no reason to think that bear markets are over. At the same time, this is a country with a very robust and resilient economy. Markets will have their painful moments, no doubt, but I’m optimistic about the long-term growth prospects of the US economy, its companies, and therefore its stock market.

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