How High Could The Dow Go?

6/23/2014


While the Dow Jones Industrial Average is sometimes criticized for comprising only 30 stocks, it tends to track broader indexes like the S&P 500 fairly closely. Moreover, the comparatively small number of stocks in the Dow makes it easy to assess its individual components, allowing for thought experiments that can help put the market's prospects in perspective. The same is true for the 20-stock Dow Jones Transportation Average. For example:

• Assuming all 30 companies in the Dow Industrials exactly meet consensus per-share-profit forecasts for their current fiscal year — and all 30 stocks maintain their current trailing price/earnings ratio — the average would trade at 17,626 in early 2015, up 4% from current levels. Using the same assumptions, the Dow Transports would trade at 9,071, up 11%.

• Targets jump sharply based on next-year expected earnings, reflecting fairly optimistic forecasts for 2015 results. On average, the 30 Industrials are expected to deliver 7.6% growth in per-share profits next year, versus 18.2% for the 20 Transports. Assuming all 30 Industrials exactly meet next-year estimates and maintain their current P/E, the average would trade at 19,259 in early 2016, up 14% from current levels. For the Transports, the equivalent target is 10,713, up 31%.

• Only nine of the 30 Industrials trade at a discount to their historical 10-year norm for trailing P/E, while only six of the 20 Transports trade at a discount. The average Industrial trades at a 3% premium to 10-year norms, versus 11% for the average Transport. So, an assumption that P/Es will remain unchanged may lead to overly optimistic price targets. Assuming all stocks trade at 10-year norms for P/E — and all companies exactly meet next-year profit estimates — both averages would be near current levels in early 2016.

• Among the Industrials, oil majors Chevron ($129; CVX) and Exxon Mobil ($102; XOM) rank among the least attractive on target prices. Neither is expected to report growth in per-share profits of more than 6% in either 2014 or 2015. Yet both trade at substantial premiums to five- and 10-year norms.

• For the Transports, much depends on the airline group. Southwest Airlines ($27; LUV) trades at a slight discount to 10-year norms for P/E, but the other four airline stocks trade at premium valuations. All but Delta Air Lines ($39; DAL) are expected to report double-digit profit gains in the current year, while next-year profits are expected to be up at least 12% for all five. Can airline stocks maintain their richer valuations and operating momentum amid rising energy and labor costs? For the Transports, with about 16% in airlines, the answer to that question is crucial.

Conclusion

While there is nothing magical about 10-year average P/Es, upside is limited if valuations revert to historical norms — especially if current profit projections prove optimistic. Valuations are not extreme, but a big near-term surge in the market could leave stocks vulnerable to a correction or worse. For now, with the primary trend bullish, our buy lists have 96.3% to 99.6% in stocks.


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