Dow 12,000: Whoop-De-Doo

The market's best-known benchmark keeps rising, but investors are underwhelmed. They might want to take another look

At long last, the Dow Jones industrial average has breached 12,000. The market's six-year ordeal, spanning the tech crash, corporate scandals, and Wall Street double-talk, is over. You can once again mention stocks at cocktail parties and even open up your 401(k) statements. Come on, feel the noise!

O.K., maybe not.

The blue-chip benchmark has indeed surpassed the old record of 11,723 touched in January, 2000. In fact, the Dow is posting new closing highs with regularity -- four days in a row, at one point in October. But if the old record was noteworthy for the way it reflected a national zeitgeist, this one is notable for its sense of anticlimax. Last time, even Carmela Soprano was picking stocks. This time, people barely think about them. "CNBC may be making a lot of Dow 12,000," says Strategas Research Partners chief investment strategist Jason D. Trennert. "But the average investor is not."

That, ironically, might be the better news.

It's not difficult to see why investors are underwhelmed. The Dow is at a record, but that's thanks largely to its antiquated method of price weighting, which gives high-priced shares more clout in the overall average than low-priced ones. For example, IBM (IBM ), a $92 stock, has nearly triple the weighting of $35 General Electric Co. (GE ), a more diversified company worth $220 billion more than Big Blue.


There just isn't much joy in celebrating an index in which only 10 of 30 components are near a record. Credit Exxon Mobil and United Technologies (UTX ) for the Dow's recent strength. But those stocks have made a much smaller impact on another blue-chip gauge, the Standard & Poor's 100-stock index, which is down 24% from its record largely because it's weighted by market cap. In fact, 15 of the 20 most widely held stocks in customer accounts at Merrill Lynch & Co. (MER ), are off their all-time highs, and not by a hair: The average decline is 48%.

The view doesn't look much better from on high. The bigger Standard & Poor's 500-stock index, which serves as the benchmark for most money managers, would have to rally 12% to revisit its record. And the NASDAQ would have to more than double. These numbers aren't adjusted for inflation; doing so would put even the record-setting Dow below its 2000 peak.

Yet many of the reasons why the record itself is meaningless suggest that stocks might actually be at the start, rather than at the end, of something big. No one can predict the future, of course. But for all the hype over the recent records, the U.S. market is unquestionably a lot cheaper now than it was at the time of the Dow's last fateful peak.

What has historically driven the stock market is valuation -- that is, the relative amount investors are willing to pay for a slice of a company's earnings. Profits are booming, but investors have been stingy. Despite 13 consecutive quarters of double-digit earnings growth, the S&P 500 has seen its forward price-to-earnings multiple slip to where it was at the start of 1996. That's less than both its 10- and 20-year averages. The profit surge should continue: Eight of the 10 S&P 500 sectors saw earnings expectations rise in October. "Stocks are still way behind earnings," says Trennert, "and the multiples keep coming down. There's just not a whole lot of investor enthusiasm."

The biggest stocks are cheapest of all. Citigroup (C ) notes that just as the Dow was getting over the 12,000 hump, the largest 25 stocks in the S&P 500 were trading near 20-year-low valuations relative to the broader market. Yet even that won't convince Ramin Kohanoff, an owner of Los Angeles gas stations and car washes who got burned in 2000 and 2001, to get back in. "It messed me up," he says. "I don't play with the stock market anymore. Dow 12,000? I don't care."

Such caution is common these days. Despite an environment of record earnings and stock buybacks, only one sector has seen its earnings multiple rise in the past three years -- utilities. "How exciting," deadpans Michael G. Thompson, director of research at Thomson Financial, of an industry known for glacial growth and reliable dividends. "Twelve thousand is a nice round number, but the valuations are nothing to brag about."

While U.S. stocks are indeed rising, it's more of an upward drift than a surge. Investors have been most aggressive overseas. In September, three-quarters of the $12 billion earmarked to equity mutual funds was directed to global and international investments. Says Oak Associates Ltd. chief investment strategist Edward Yardeni: "Investors remain uninterested in the U.S. stocks that made them money in the 1990s and lost it for them in the early 2000s." It's hard to attract investors to U.S. shares when emerging market economies are thriving anew and even sleepy France and Germany are offering better returns.

The good news for the Yanks is that the gap is narrowing. Emerging market stocks have trounced U.S. stocks throughout the decade -- but this year, emerging markets have outperformed the U.S. by only five percentage points. And since May, the U.S. is winning.

The competition inside the U.S. is getting easier, too. Housing and commodities are tanking, suggesting that a tipping point toward U.S. shares may be nigh. "What has been working will not work anymore," says UBS (UBS ) strategist Thomas M. Doerflinger, who studies investor attitudes. "People will appreciate that they can do much better in the stock market than in other asset classes."

That could happen in the typical U.S. household. Doerflinger notes that as households saw their direct investments in corporate stocks fall from 20% of their overall worth in 1999 to 9% in 2006, the real estate chunk rose from 22% to 32%. Today's mix is roughly the same as it was in 1990. But the tables are turning. New home prices plunged 9.7% from September, 2005, to September, 2006, whereas the S&P 500 gained 9.5%. With home prices no longer rising, the sector isn't likely to attract new speculators. Whereas a stock must fall to zero to wipe out an investor, a house need only fall a smidge to wipe out the equity of a buyer betting with a 3% downpayment mortgage.

As the housing market began to fall, interest rates remained buoyant. Investors' knee-jerk reaction has been to park money in cash, not stocks. Trennert notes that aside from the crash-induced rush to cash between 2000 and 2002, money-market fund holdings as a percentage of the total U.S. equity market are the highest they've been since 1992.

Yet the allure of cash is questionable. Short-term rates have risen from around 1% to more than 5%. But even a 5% yield on a one-year certificate of deposit is effectively cut in half by taxes and inflation. Stocks, on average, have returned about 10.5% annually over the long run. Cash would become even less attractive if the Federal Reserve were to cut interest rates, an event some market watchers are predicting for 2007.

The upshot: Stocks seem appealing merely by process of elimination. With commodities, housing, and cash all losing their luster, money should increasingly move elsewhere. All the noise surrounding Dow 12,000 could prompt the kinds of inflows needed to bring the market higher, particularly if international stocks pause to catch their breath. "There's lots of pent-up demand," says Trennert. "You have a lot of rally room when people look at their statements, like what the U.S. offers, and their buying begets more buying."

"Investors want to see some performance," adds Yardeni. "They tend to get in a year or two into it." He has his eyes on January and February, when investors usually focus on financial planning and many decide where to put yearend bonus money.

Of course, much of today's lukewarm sentiment for equities is a vestige of the deep heartbreak investors felt the last time around, when stocks were all-consuming and NASDAQ 5,000 was just another stop on the road to New Economy nirvana. Says Citigroup strategist Tobias M. Levkovich: "What really excited investors was the sense of boundless upside -- that it could only go up." But as the go-go NASDAQ fell 4,000 points in a blaze of scandal and earnings restatements, many investors resolved to hold anything but stocks. Today, the bulls' sober case is one of valuation and a reversion to historical patterns -- hardly the stuff of an overactive imagination.

Which suits optimists just fine. "The less people care," says Levkovich, "the better it is for the market."

By Roben Farzad

    Before it's here, it's on the Bloomberg Terminal.