Top Gun FP Client Note: Dow 15,000

NOTE: Every week or two I write a Client Note for my clients.  For a limited time, I am allowing non-clients to sign up and receive it at the same time as my clients.  You can sign up at the top right hand corner of the website.  I will also be posting the notes on my blog with a time delay from time to time.

Originally sent to clients February 15.

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Based on cyclical patterns of market history, the odds are better than two chances in three that the Dow Jones Industrial Average will reach 15,000 or higher over the next two years.  Based on the same cyclical patterns, there’s about a 50-50 chance that the Dow could hit 17,000 or more.

The market history draws on 141 years of equity performance, from which a fairly straightforward cyclical pattern can be discerned: a strong tendency for periods of worse-than-average returns to be followed by periods of better-than-average, and vice versa. Since the past five years have been squarely in the worse-than-average category, better-than-average returns in the two-year period just begun are now likely.

The cycles, then, are based on simple arithmetic: two-year intervals following intervals of five years. Also, five-year intervals that are worse-than-than average are objectively defined as belonging to the lowest quartile of all five-year periods in the 141 years tracked. Two-thirds of the time, after a five-year period like the one we’ve just seen, the market rises fast enough to lift the Dow to 15,000 or higher from present levels over the following two years. The same pattern applies to Dow 17,000 or higher, except that happens just half the time.

- “Enter The Bull”, Gene Epstein, Barron’s, February 11

The cover of Barron’s this weekend read “Dow 15,000″ in large print.  The article by Gene Epstein reviews the research of Wharton Professor Jeremy Siegel, author of Stocks For The Long Run, to make a historical case that there is a 70% chance that the Dow reaches 15,000 within two years.

The argument is straight forward and compelling.  Siegel uses his stock market data going back to 1871 to break the market into 136 5-year periods.  The 5-year period ending in 2011 falls into the bottom quartile of 5-year periods based on returns.  For the 33 previous bottom quartile periods, the median return the following two years is 20%.  Therefore, they argue, the Dow has a 50/50 chance of reaching 17,000 within two years.  In 23 of the previous 33 bottom quartile periods, stocks returned 11.7% or greater the following two years.  Therefore, the Dow has a 70% chance (23/33 = 70%) of reaching 15,000 within two years.  In only 3 cases were the following two year returns negative.

I don’t care to go into detail refuting the argument.  I will only point out that 30% of the time, the historical record would suggest we don’t reach Dow 15,000 and 10% of the time it suggests we will be lower two years hence.  In addition, within the 5 years ending in 2011, we have already had an excellent 2-year period (2009-10).

More interesting to me is the light the cover sheds on sentiment.  The magazine cover indicator is one of the most well known on Wall Street and says that we tend to see covers like this at points of extreme sentiment.  The most famous example is Business Week’s “The Death of Equities” which appeared in August 1979 near the end of the nasty 1970s bear market.

This week must be a week of round numbers because the other number everyone is talking about is Apple $500.  Apple closed above $500 on Monday and everybody is speculating on what it means.  Is it time to sell Apple?  What does it mean for the overall market?
 
The most common argument against Apple now seems to be that it is just too big to keep going up.  With a market cap of almost $500 billion, Apple is now the most valuable company in the world.  It is worth more than Microsoft and Google combined. 
 
I say “So What?”  Fundamentally, the limit on a company’s sustainable valuation is earnings not size.  Analysts are forecasting Apple to earn $40 billion this fiscal year.  It earned $33 billion in calendar 2011.  With almost $100 billion in net cash on its balance sheet, Apple is actually still undervalued.  Just because we have never seen anything like this before, doesn’t mean it can’t happen.
 
Consider the comparison to Microsoft and Google.  Combined those two companies have a market cap around $450 billion.  Subtract $80 billion in net cash and you are paying $370 billion for their businesses - about the same as Apple after backing out its cash ($487 billion market cap – $97 billion net cash = $390 billion).  Together they earned $35 billion in calendar 2011 – $2 billion more than Apple.
 
If you could own Apple or Microsoft and Google, which would you choose?  It’s a tough question and one that reasonable people can disagree on.  Apple is growing faster but Microsoft and Google’s market positions may be more firmly entrenched.  At any rate, the comparison does not prove Apple’s size or valuation to be absurd.
 
It is, however, important to distinguish Apple’s tremendous performance from that of the rest of the market.  Because of Apple’s great size and earnings, it is distorting numbers for the overall S&P 500.  A number of analysts are now reporting numbers for the S&P and the S&P excluding Apple.  Note that for all the companies in the S&P 500, earnings are on track to post a 6.6% year over year increase for the 4th quarter.  Exclude Apple and the growth rate shrivels to just 2.8% (“Apple’s Size Clouds Market”, The Wall Street Journal, February 15, C1).
barrons-dow-15000
 
business-week-the-death-of-equities
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Greg Feirman
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Top Gun Financial (www.topgunfp.com)
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