Why Dow 10,000 no cause to celebrate

The Dow Jones Industrial Average closed above 10,000 last Thursday, its first time in 18 months, and Friday. But it's no cause for celebration.

This point has been made before -- in a Dow 10,000 column on March 23, 1999. That was just six days before the Dow industrials closed above 10,000 for the first time. The headline: "Dow 10000? Prepare for the Hangover."

The column didn't forecast a stock-market crash.

Instead, it argued that, while the market's rapid rise might be good news for anybody looking to sell stocks, it was bad news for those planning to add fresh savings to their portfolio. As stocks clambered to loftier levels, it meant every dollar invested would earn lower returns in the years ahead.

Much has changed since 1999. But that brutal truth of investing, that a skyrocketing stock market effectively borrows returns from the future, is as true today as it was in 1999.

Dow 10,000? Forget the party hats.

Expecting less

In the March 1999 article, I noted that returns over the next decade were unlikely to match the long-run stock-market average, which then stood at eight percentage points a year above inflation, as calculated by Chicago's Ibbotson Associates Inc. That is still the case.

A hefty portion of the stock market's impressive inflation-beating gain has come from dividends, which added more than 4 percentage points a year to long-run returns, and from a rising price-earnings multiple, which bolstered historical performance by more than a percentage point a year.

But now, as in 1999, there is a far more richly valued market. That means the market's P-E multiple isn't likely to expand much more, and there's a decent chance it could contract. Meanwhile, the market's dividend yield, currently 1.6 percent, remains miserably low.

The implication? Suppose, in the decade ahead, that earnings per share climb 3 percentage points a year faster than inflation. If you take that 3 percentage points and tack on today's 1.6 percent dividend yield, the Standard & Poor's 500-stock index would outpace inflation by some 4 1/2 percentage points a year over the next decade -- assuming the market's P-E holds steady.

It might seem like the outlook ought to be brighter, especially after experiencing the recent brutal bear market. But unfortunately, stocks today aren't much cheaper than they were in 1999, thanks to the dismal performance of American business.

The S&P 500 companies will pay dividends this year that are just 4 percent higher than those paid in 1998, estimates Standard & Poor's, a unit of McGraw-Hill Inc. What about corporate profits? Amazingly, reported earnings for the past 12 months are only marginally higher than they were when the Dow first crossed 10,000.

Despite this stagnant corporate performance, stocks appear slightly more appealing. The reason: While the Dow industrials may almost be back to 10,000, other indexes are still well below their levels of March 29, 1999, when the Dow first closed above 10,000.

The S&P 500, for instance, is down 19 percent from its closing level on that day. As a result, the S&P 500 today is at 27 times reported earnings, versus 35 times earnings in March 1999.

Even though stocks are no bargain, we most likely are on the cusp of another major market decline. Corporate earnings in 1998 and 1999 reflected a long economic expansion and some highly dubious accounting.

Today, by contrast, we are in the early stages of an economic recovery and presumably the accounting problems have been corrected. Indeed, robust profit growth should be seen next year and probably into 2005.

Hedging your bets

With stocks so pricey, the 1999 column suggested readers lower their performance expectations and save more, thereby compensating for lower returns. That still seems like good advice.

The column also offered some recommendations from William Bernstein, an investment adviser in North Bend, Ore.

He advised shifting money into real-estate investment trusts, high-yield junk bonds and inflation-indexed Treasury bonds. REITs and inflation bonds were stellar performers in the subsequent bear market. Junk didn't fare quite so well, though it did handily outperform stocks.

But today, Bernstein isn't banging the table for any of these investments.

"The expected return on inflation-indexed bonds is fair, but not spectacular," he said. "Real-estate investment trusts are trading at historically low yields. And as far as junk bonds go, you're just not being paid for the risk of owning them."

Bernstein characterized U.S. stocks in the same way: "The Dow might be where it was in March 1999," he noted. "But the broad market has certainly come down in price. People shouldn't be as worried about stocks as they were."

What to do? For those inclined to overweight attractive market sectors, 2004 no doubt will offer plenty of market turmoil and, eventually, some intriguing opportunities. But for now, it seems smarter than ever to take the prudent course, which is to spread your investment bets widely and avoid banking too much money on any one sector.