Dow Jones valuations are just getting tougher

With the Dow Jones Industrial Average firmly under 7,000, the US stock market is now well below its early-1995 level, adjusting for changes in nominal GDP.
That suggests it is cheap, assuming growth prospects are as good as they were back then. But there is a risk to such a an analysis: too much fiscal and budgetary stimulus could bring on growth-stultifying inflation.

Fast back to December 5, 1996. The Standard and Poor's 500 Index closed at 744.38. That evening, Fed Chairman Alan Greenspan decried the market's "irrational exuberance". On the S&P's close of 700.82 on Monday, the market is clearly exuberant no more.
It is not, however, exceptionally low. Greenspan announced a new easier monetary policy to Congress later in early 1995. That day, the Dow Jones average, which had been generally rising since 1990, first reached 4,000. Adjusting for the 95pc increase in nominal GDP since that time would give an equivalent Dow level today of around 7,800. That suggests that current levels are only somewhat below their long term trend, and that the 1996-2007 period represented a lengthy bubble.
As for the S&P 500, Standard and Poor's currently projects 2009 earnings on the index of $48.10. Over the 20-year period to 2008, it traded at an average of 19.4 times earnings. That would imply a current value of 933.14. That 20-year period however includes the 12-year bubble. Taking a longer-term average of around 15 times earnings gives a valuation of 721.5 - again, just slightly above the current level.

So, based on 1995 stock prices and long-term earnings considerations the market is just below a middling valuation. However that assumes US growth and earnings prospects are as good today as they were in 1995, or over the long-term average.
That's where doubts creep in. If the exceptional monetary stimulus since September produces inflation, which needs to be squeezed out, or the unprecedentedly large budget deficits in fiscal years 2009 and 2010 "crowd out" private investment, then growth and earnings prospects for the next few years would be below average.

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