• Tony Hayes CFA

Still climbing the wall of worry.

As the song goes "Don't Worry, Be Happy". Too long have we been mired in Calvinistic pessimism anticipating "the end of days". It is a bull market so be really bullish.

A year ago I was premature in my forecast of the DJIA reaching 30,000 by the end of 2018. It now looks as though this landmark could be reached either by the end of this year or in early 2020. As a career sell-side analyst, I was frequently criticised for being three months too early. Better to be too early than too late, thought I! Besides, the 2018 Christmas Eve Massacre was totally unwarranted as demonstrated by the rapid rebound. More worry, worry, worry!

Worry, to the point of irrational pessimism and sheer terror has been the hallmark of investors' collective attitudes during the entire post-Lehman decade. The worry seems to stem from a pervasive fear of history being about to repeat itself at every blip and burp on the economic landscape.

T Bond yield: Equity yield Ratio

The 30-year T bond yield: equity yield ratio has been a good indicator of when market participants were irrationally exuberant as in the summer of 1987 and the latter part of the 1990s, shown as the black line in the following chart. Since Lehman, the same players have been irrationally pessimistic.

The red line in the same chart is the actual price of the DJIA over the same period. Despite the heightened state of worry, the DJIA price has been moving up. Indeed whenever the ratio fell below 1 into the area denoted as sheer terror it was an excellent time to "buy and take no prisoners". With the ratio hovering close to 1 the DJIA is still very much a screaming buy as new record highs seem certain to be attained in the months and year ahead despite the pervasive gloom and the ridiculous claims, spuriously based on Newtonian physics, that "What goes up must come down".

As long as the ratio is below 2.33, I expect the DJIA price (the red line) to continue to rise. Right now, market participants are still irrationally pessimistic and very close to being in sheer terror of another financial meltdown.

A far more modern scientist to follow in terms of the stock market would be Einstein with his theory of relativity. In this case, it is the yield of the US 30 year T bond relative to the yield of the DJIA.

The value of the US 30 year T bond is inversely proportional to its yield. As the yield of new bonds rise the value of an existing bond will fall. and vice-versa. As the risk for US Treasuries of the same maturity is the same, the only vector affecting the bonds is the yield so the value and the prices are the same. Not so in the case of equities.

Rising Dividend and Falling 30-Year T-Bond Yield = Potent Profit Formula

The two vectors that determine the dividend discount value of the DJIA are its actual dividend and the yield of the 30-year T-bond. A rising dividend pushes up the value of the DJIA as does a falling T-bond yield. These positive conditions have both been in effect for the past four decades.

The drop in the 30 year T Bond yield from 15.2% on September 29, 1981, to  2.3% on November 15, 2019, resulted in the great bull market in bonds which increased 6.61 times. This was one of the two major factors in the advance of the DJIA over the same time. The other vector was the 11.13 fold increase in the DJIA dividend.

Combining the two vectors, the dividend discount value of the DJIA rose by 6.61 X 11.13 = 73.55 times. From the starting value and price of 848 on September 29, 1981, the value of the DJIA on Friday, November 15 has reached 62,363. This compares with the DJIA price of 28,005, which suggests strongly that the pressure on the DJIA price remains decidedly up. 

Dividend Discount Value of DJIA and Its Price

The next chart shows the relationship between the 30 year T bond yield and the DJIA dividend yield since 1981.

Since Lehman, the price of the DJIA has remained below its value because of FEAR of a repeat of the financial crisis. However, it is because the price has remained significantly below its value, that I have been so super bullish DJIA throughout and remain unabashedly so.

A shorter-term chart of the relationship between the DJIA value and its price is shown below to emphasise the continuing under-pricing of the DJIA and why the bull market is unlikely to end anytime soon.

3 Triggers that could push the Value and Price of the DJIA to Equilibrium

  • First and foremost would be changes in either or both the 30 year T bond yield or the dividend of the DJIA. If the bond yield were to rise then the discount value would fall. The same would happen if the dividend were to fall. However, a dividend decline would imply a weaker economy and the bond yield would probably fall, resulting in a stabilization of the equilibrium point. The outlook however, is for lower interest rates for longer and continuing dividend growth over the next couple of years.

  • Second, stock buybacks are a symptom of corporations investing where they see the best returns and the only thing that looks attractive is their own companies but so far have been hesitant to invest in capital expenditure. M&A activity is also ripe as many companies see value in the depressed share prices of others. This stems probably from the pessimism in the market place and the short-termism of portfolio managers and algo-driven traders who have programs based on the most recent action of prices rather than anything to do with fundamentals.

  • Third, insurance and pension funds are having a tough time meeting their actuarial requirements in the bond market so they are having to diversify into what might have been traditionally been deemed to be more risky assets. Equities offer at least the same coupon as the 30 year T bonds. More important, however, equity coupons or dividends have tended to grow over time. It is possible to see a shift by pension funds and insurance companies to increase their weightings of equities. On the basis of the dividend discount value of the DJIA, this should continue to push the price of the DJIA upwards towards today's equilibrium value of 62,363.

Sources Charts by the author from data provided by the Federal Reserve and Dow Jones.

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