Putting The Dow's Fading Pulse In Perspective

Just how low are we on the Dow Jones Industrial Average? That simple question is one of the most important we may ever ask ourselves, financially speaking. At the close of trading Thursday, with the DJIA down more than 50% from its October 2007 peak, I sat down to noodle over this question, thorny and asterisk-ridden it may be.

Data Sources
The historical data I'm using comes from Robert Shiller of the Yale School of Management and the National Bureau of Economic Research (NBER). Shiller's historical data, which actually tracks the S&P 500, is the de-facto standard of reference used by most economists and analysts. For the purposes of looking at historical U.S. stock valuations, we can use the S&P 500 as a fair proxy for the Dow Jones.

Let's start by getting the boilerplate, "gotta have 'em" numbers out in the open. These are fresh of the press from Thursday's close, and include two quick asterisks*

* Remember that the DJIA is a price-weighted index, which means that "expensive" stocks (as measured by share price) affect the average more than low-priced stocks, regardless of their respective market caps. To account for the actual percentage weightings, we should be looking at weighted-average metrics, not simple arithmetic averages. The latter is what you'll see below. (To learn more about how the Dow is calculated, read our related article Calculating The Dow Jones Industrial Average.)

* In the same vein, current DJIA members General Motors (NYSE:GM) and Citigroup (NYSE:C) have become nearly non-entities in the past week, in terms of their power to affect the DJIA. GM and Citi shares, because of their low prices, now make up - combined - less than 1% of the Dow Jones Industrial Average.

Boilerplates
The current price-to-earnings (P/E) of the Dow is 10.26 based on trailing earnings, while the forward P/E is 9.59. One could make great arguments that the "E" in 2009 earnings is due for more downward revisions, so if all known data was perfect, I'd suspect the forward P/E to be higher. The price-to-sales (P/S) has been a bit overused and understated in some recent media pieces, as I've heard people call the number as low as 0.7 this week. I think if one used simple averages that overstated say, GM's effects on the Dow, you could get to 0.7. But my weighted average calculation came up with 1.21, still an ultra-low measure in most every historical period. But we have been lower, such as in the early 1980s when the P/S got all the way down to 0.5. It's worth noting again, though, that if GM was a larger part of the Dow, its 0.01 P/S figure alone would knock the whole index down below 1.

The last metric I'll throw out here is the price-to-book (P/B), which today comes in at 2.53. This is not particularly low by historical standards, but results are again skewed by high P/B ratios for what are now the Dow's biggest components: names like McDonald's (NYSE:MCD), Microsoft (Nasdaq:MSFT), Johnson & Johnson (NYSE:JNJ) and 3M Corporation (NYSE:MMM) generate substantial cash flow and have retained their brand quality through the past year.

Historical Perspective
So, where does this stand in terms of history? We have seen lower P/Es just a few times, such as in the early 1980s and following the Great Crash of 1929. But we never saw P/E levels stay this low for long, and it's important to understand why. The business cycle is an unavoidable part of the economy, and stock prices over time have reflected this knowledge when P/E have actually risen during recessions. (To learn more, check out The Crash Of 1929 - Could It Happen Again?)

The market anticipates trough earnings, and is able to place a higher multiple on them knowing that growth rates will be much larger when the economy turns. The only macro factor that can alter this is prolonged high interest rates, like we saw in the early 1980s. In that period, P/E levels remained below 10 for several years as inflation ate away at nominally higher equity returns.

Where We Go From Here
Could the markets fall farther? Most certainly. Not only is there a historical precedent, but markets are acting as irrationally as I've ever seen them act. But the one thing that really jumps out at me is the fact that we're in a low/no inflation world, so the 1980 valuation precedent shouldn't be able to hold up today. If we can hold the stagflation effects aside, we are certainly seeing some of the most attractive stock valuations in the past 40 years.

As I look across the DJIA, I see stock prices that may literally never come our way again. Here's my list of the deepest of the deep value stocks in the Dow; I'd call them the Dogs but this year, every stock is a Dog of the Dow. One attractive incentive to wait out a rebound today is the dividend yield on the Dow of 4.2%, the highest level in over 25 years. (To learn more about the Dogs of the Dow strategy, read Barking Up The Dogs Of The Dow Tree.)