Dow 60,000? What Are the Odds?

It's a crazy-sounding target, but there's decent logic behind it

By Will Ashworth, InvestorPlace Contributor

Dow 60,000: It’s the kind of number generally thrown out by analysts and pundits to get attention — mostly because it works. And it’s the exact number floated by billionaire money manager Ron Baron during his July 8 CNBC appearance.

In his segment, Baron said he believed the Dow Jones Industrial Average would hit 60,000 in 20 years. While we’ve heard big predictions like this in the past; the reality is usually far different … and with the Dow sitting at roughly 15,300, it seems incomprehensible that 30 blue-chip companies could gain 45,000 points by 2033.

I’ll look at why it could, why it couldn’t, and the odds of it actually happening.

Why It Could

The math here is fairly simple: To get to 60,000, the Dow Jones needs to achieve a compound annual growth rate of 7.1% over the next 20 years.

Getting there isn’t nearly as simple.

In a November 1999 Fortune article, Warren Buffett discussed the three things necessary for investors to make money in the markets:

  1. Falling interest rates
  2. Corporate profits as a percentage of GDP rising dramatically
  3. Corporate profits consistently increasing by 3% annually with inflation taken into account.

How have we fared since Buffett first spoke about this subject?

  1. In November 1999, the 10-year Treasury yielded 6.03%. As of today, it’s down to 2.64%. Goldman Sachs predicts it will hit 4% by 2016, but that’s still well below the 1999 mark. Put a checkmark here.
  2. According to St. Louis Federal Reserve Economic Data, corporate profits as a percentage of GDP has grown from around 5.6% in 1999 to over 11% today. Another checkmark.
  3. The Dow Jones Industrial Average’s earnings per share in March 2000* was $499.06. As of the end of June, its 2013 EPS estimate was $1,112.81, which is a compound annual growth rate of 5.8% — well within Buffett’s 3% guideline. That’s check No. 3.

And yet, since March 2000, the Dow has achieved a compound annual growth rate of 2.3% — not exactly the performance you’d expect considering all three of Buffett’s requirements for making money on stocks were achieved during the past 14 years.

Fortunately, there’s a good reason for that mediocre performance.

Reformed Broker blogger Josh Brown serendipitously wrote about the subject in a May 16 post. In it, he points out why today’s market is nothing like 1999. Mind you, he uses the S&P 500 to make his case, but the same basic facts apply to the Dow as well. He essentially states that the S&P 500 is trading at a P/E of 14 compared to 33 back in 1999. Yet the index today pays double the dividend, and its components earn twice as much. In essence, investors are getting more for less.

Stocks today have a had a good rally, but it has been a broad-based upswing led primarily by institutions. The average Joe either is too scared to jump into equities or just doesn’t care. Stocks have a long way to go before they are overvalued.

So regardless of what happens in the next two or three years with interest rates and corporate profits, it’s pretty obvious that the usual drivers of stock prices have yet to be reflected in the true value of the Dow. With the economy getting stronger by the day, any reduction in unemployment will be met with greater demand from investors, large and small. The combination of these two events could lead to annual returns well in excess of the 7.1% required to meet Baron’s 10-year goal of 30000. If that happens, a couple of decent-sized recessions won’t be enough to slow the index down given its head start over the first decade.

Under these circumstances, I’d say it’s very likely that it achieves 60000 by 2033.

Why It Couldn’t

In their 1999 book Dow 36,000, authors Kevin Hassett and James Glassman (as you’d expect) predicted that the Dow would grow to 36000 within three to five years. At the time of publication in September 1999, the index stood at 10318, so both men believed the Dow would gain 26,000 points to do it. That prediction didn’t come close to fruition, with the Dow closing September 2004 at 10080 — basically unchanged.

Glassman has gone to great lengths in the Wall Street Journal and elsewhere to explain why their prediction didn’t come to pass. Chief among his reasons is that GDP growth hasn’t been nearly as robust as they projected. Their assumption was real GDP growth of 2.5%, which was slightly less than the historical norm of 3% since World War II. The actual number was just 1.8%, with tame inflation making the result even worse. Given the shortfall — combined with heightened investor fear after the dot-com bubble in 2000 — the authors didn’t stand a chance.

At the 2001 annual meeting of Berkshire Hathaway (BRK.B), Buffett argued that an investor can expect long-term returns of 6.5% based on 5% nominal GDP growth and 1.5% in dividends. Glassman and Hassett used a figure that was within a half a percentage point of Buffett’s assumption, yet failed to achieve a return anywhere close to 6.5% annually.

Ron Baron’s projection calls for 7% annualized gains over the next 20 years. Even if the GDP growth rate returns to its nominal norm of 6% with tame inflation, the dividend yield must remain higher than 2% annually in order to achieve this goal. Long-term, this seems highly unlikely because any appreciation due to stronger GDP growth will result in the yield dropping below 2%.

From the perspective of globalization maxing itself out, you have to wonder whether the Dow 30 can find enough earnings growth to double in price twice during the next 20 years.

Given recent experiences, that’s a lot to expect.

The Odds

And yet, I still think Dow 60000’s chances are actually pretty good.

Ron Baron’s not some flake, but a bonafide stud when it comes to portfolio management. Remember that before just dismissing his call. And also remember this:

Americans found out the hard way that you can’t rely on your home to fund your retirement. You have to buy equities if you have any hope of building a nest egg for retirement.

I believe America’s best days are actually ahead of it. All kinds of industries will thrive in the next three to five years; the country’s going to be in a much better position than anyone realizes or expects. The only thing that stops the Dow from hitting 60000 within 20 years is a citizenry that forgets its history (2000 and 2008) and goes back to the way it used to be.

At the end of the day, most investors who stood their ground and stayed in the markets during the 2008-09 recession have got their losses back and then some. Patience reaps rewards.

*March 2000 data used because December 1999 data could not be located.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

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