Too Much Air In The Dow?

A study finds prices are out of line

Investors may have good reason to fret about the stock market's sky-high levels. The Dow Jones industrial average is trading at near-record levels when compared with the "intrinsic value" of the 30 stocks that make up the index, according to a forthcoming study by economists at Cornell University.

Cornell's Parker Center for Investment Research keeps tabs on the relationship between the Dow and the stocks' basic value, as measured by a valuation model spelled out in a paper due to be published soon in the Journal of Finance. The Dow's 9552.68 close on Feb. 22 meant that the index was trading at 1.59 times the stocks' value (chart). That's not as high as in April, 1998, when the price-to-value ratio hit 1.74, but it's still far above normal.

It's hardly news that stocks look pricey by conventional rules of thumb: The price-to-book-value ratio of the Dow stocks has soared from 1.0 in 1970 to well over 3.5, and price-earnings ratios keep setting new highs. Many Wall Streeters, however, say these historical measures don't take into account the strong long-term prospects for the companies' earnings.

But Cornell's yardstick is different: It's based on each Dow company's individual track record and earnings outlook. In essence, Cornell's Charles M.C. Lee and Bhaskaran Swaminathan, working with James Myers of the University of Washington, have constructed a bottom-up method for valuing the Dow.

For each company in the index, the researchers took analysts' long-term earnings projections, then discounted them by the sum of two returns: the rate on Treasury bills plus the historical premium over Treasury bills of stocks in that company's industry. They then combined current values for the stocks to calculate the Dow's value.

This measure has proved a powerful tool in predicting the Dow's trend, Lee says. When the price-to-value ratio has moved far above its mean value of 1.08 in the past, it has almost invariably sunk back over 18 months or so.

Of course, the ratio can return to normal without a big fall in share prices. Rising profits can lead to a higher intrinsic value that helps close the price-value gap. "The market is generally ahead of the analysts in predicting earnings," Lee notes.

Still, even allowing for today's low interest rates, Cornell's price-value ratio is so high (more than two standard deviations above the mean, an occurrence with only 1-in-40 odds) that Lee and his colleagues doubt that earnings improvements alone can bring it back into line. Stock prices, they say, must also come down--though they're unsure just when or how hard they will fall.

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