December 31, 2021
Tracking ETF: SPDR Dow Jones Industrial ETF (DIA)
Index Overview: The Dow Jones Industrial Average is a 30-stock, price-weighted index that measures the performance of some of the largest U.S. companies. The index provides suitable sector representation with the exception of the transportation industry group and utilities sector which are covered by the Dow Jones Transportation Average and the Dow Jones Utility Average respectively. When Charles H. Dow first unveiled his industrial stock average on May 26, 1896, the stock market was not highly regarded. Prudent investors bought bonds, which paid predictable amounts of interest and were backed by real machinery, factory buildings and other hard assets. Today, stocks are widely accepted as investment vehicles, even by conservative investors. The 30 stocks now in the Dow Jones Industrial Average are all major factors in their industries, and their stocks are widely held by individuals and institutional investors. Besides longevity, two other factors play a role in its widespread popularity: It is understandable to most people, and it reliably indicates the market’s basic trend. Sources: DJAverages.com and spindices.com
Analyst Notes: Analysis by Allen Gillespie, CFA (864) 288-2849
Are Stocks Too High to Buy?
A Bitcoin Gold Dow Theory & Benjamin Graham
Analysis of the Dow Jones Industrial Average ETF
In his investment classic, The Intelligent Investor, the father of security analysis Benjamin Graham endeavored to answer the following question:
“Is the stock market too high for conservative purchase?”
He recommends methods by which a defensive investor might determine the appropriate asset allocation and simple methods by which to value securities to develop long term return expectations. He defined a defensive investor as one that is “interested chiefly in safety plus freedom from bother.”
He also defined an “investor” and a “speculator” with his famous statement that “an investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” He argued for a 50/50 split of funds between stocks and bonds for defensive investors, unless the weight of the evidence suggested a tilt toward a 75/25 or 25/75 mix.
In this analysis, I seek to logically implement his recommendations by analyzing the Dow 30 by using data from ValueLine, MarketSmith, Bloomberg, Barron’s, and FinTrust while also adjusting for inflation by using Bitcoin, gold, and cryptocurrency staking rates to derive estimates of real prices.
Year-End 2021 Analyst Highlights
- Our current analysis suggests levels below 32,379 on the Dow Jones Average would be considered below average, while a level closer to 25,713 would represent low prices, while an index level of 39,046 would be considered rich in relation to past sales, earnings, book value, dividends and forward analyst estimates. Given the current risk to reward ratio, FinTrust is maintaining its HOLD rating for the Dow Jones Industrial Average exchange traded fund (ETF symbol: DIA), as the market is currently 12% above the midpoint of our 2022 estimated price range and the risk-reward ratio is poor.
- The data suggest an allocation for defensive investors of 45/55 currently. Equities are currently 112.2% above the midpoint of our estimated valuation range, and gold still appears undervalued relative to equities. As in years past, I would recommend investors proportionately decrease or increase their equity allocations proportionately to where stocks relative to our estimates levels.
- Today, the tangible book value of the Dow sits at $6,543 so I am maintaining my gold price target of $6,688.
- Today’s estimated ranges for the Dow Jones Index less our gold price target yields an implied bitcoin target range of $29,795-$32,358.
- As in our previous reports, the data suggests that for the “defensive investor” reasonable allocations, toward the common stocks of the Dow Jones Industrial Average levels appear appropriate and reasonable. For fixed income investors, I continue to recommend inflation protected, tax-free, floating rate and high-quality bonds, while for aggressive investors I recommend gold equities, gold, and cryptocurrency in place of short-term fixed income and money market holdings.
Risks to the Recommendation:
- Risks include, but are not limited to, (1) Unanticipated changes in inflation, interest rates and industrial production (2) credit risk (3) regulatory, governmental, and tax law changes (4) product and business risks (5) the mere fact the future is uncertain (6) political risks (7) and all other risks normally associated with investments in common equities, gold, and cryptocurrencies.
Current Share Price
52 Week Price Range
Fintrust Brokerage Services, LLC rates companies a BUY, HOLD, SELL, or SHORT.
- A BUY rating is given when the security is expected to outperform the broad equity market as measured by the S&P 500 on a risk adjusted basis over the next year.
- A HOLD rating is given when the security is expected to perform in line with the broad equity market as measured by the S&P 500 on a risk adjusted basis over the next year.
- A SELL rating is given when the security is expected to perform below the broad equity market as measured by the S&P 500 on a risk adjusted basis over the next year.
- A SELL SHORT is given when the security is expected to decline in value over the next year.
The distribution of ratings across Fintrust’s entire company universe is 57.1% Buy, 35.7% Hold, 7.1%Sell, and 0% Short
Key Figures (Dow 30 @ 12/23/2021)
Key figures pricing data reflects previous trading day’s closing price. Other applicable data are trailing 12-months unless otherwise specified.
Book Value $
Earns Yield %
Divs Yield %
What I Wrote in December 2020
“Much like last year’s analysis, the current low levels of dividend and earnings yields and interest rates suggest a fair degree of caution….Based on an earnings retention rate of 41.59% and a return on average equity of 15.4% the implied expected book value growth for 2021 would be a solid 6.4%, which when added to an initial 1.97% dividend yield would led to an expected 8.36% total return under average conditions. While impressive and consistent with historical ranges, I continue to point out that earnings have yet to turn upward, interest rates are severely depressed, corporate and government deficits are higher, and currency values are in flux.”
“My analysis suggests levels below 27,378 on the Dow Jones Industrial Average would be below the 10-year average, and levels closer to 21,994 would represent low prices relative to the average results, while an index level of 32,761 would be considered rich in relation to past sales, earnings, book value, dividends and forward analyst estimates. The data suggest that for the “defensive investor” reasonable allocations toward common stocks at today’s levels appear appropriate and reasonable. Given the components of the Dow 30 collectively appear to trade at slightly above average levels (29,910 v. 27,378 or 109.25% of average), portfolio policy for the “defensive investor” should lean toward average equity allocations (so if one normally splits funds in a 50/50 ratio, the analysis suggests a 45/55 ratio).”
I continued with the following:
“I am more confident in the analysis now than last year given that earnings have declined to recessionary lows, but I remain concerned in my analysis given the suppressed nature of global interest rates, as both equities and bonds may be mispriced. Despite trading near the midpoint of my estimated range, the case for equities at today’s prices is still not so compelling when compared to high quality bonds and alternatives, as to lead a defensive investor to completely abandon balanced asset allocations in search of a little more growth and income…prices below 27,378 on the Dow Jones Industrial Average would appear reasonable, while prices above 32,761 would appear to be too high for the defensive investor. Prices close to 21,944 would be low in relation to past multiples…”
What Has Happened Since Our December 2020 Report and Our Mid-2021 Update
Mid-year 2021, we provided an update because we considered an index level of 36,686 at that time to be rich in relation to past sales, earnings, book value, dividends and forward analyst estimates, and we downgraded our market outlook.
The Investor and Inflation (Real v. Nominal Prices)
Investors should invest to increase or maintain the real purchasing power of their savings. In this effort, investors have traditionally used both technical and fundamental analysis to determine the appropriate prices for securities. Two of the oldest methods of analysis involve Dow Theory, to determine the economy’s direction, and a Benjamin Graham analysis of security values to determine the appropriate values for securities.
Beyond normal analysis difficulties, which prior methods sought to solve, the modern analyst must now also content with the unprecedented degree of economic deformation wrought by central banks and central planners. Central bank policies target nominal prices, prevent distressed selling, and created a monetary hall of mirrors for asset prices. Nominal prices have separated from fundamental values by what I term the “asset price inflation monetary gap.”
Today’s asset price inflation monetary gap, and the changing nature of the economy have distorted security analysis, unless the modern analyst adjusts security values from nominal prices into real price equivalents, and adjusts from controlled interest rates into free market equivalents.
The Quagmire of the Asset Price Inflation Monetary Gap
Global central banks and treasury departments actively lend at subsidized rates. and they buy both fixed income and equity securities with newly printed money on a near daily basis. As a result, the Bank of Japan and the Swiss Central Bank now rank among the Top 10 holders of a broad range of equity securities. For example, in its last 13-F filing the Swiss National Bank reported holding 65,984,108 shares of Apple, 28,291,355 shares of Microsoft, 10,412,716 shares of Johnson & Johnson, 9,680473 shares of Proctor & Gamble, 6,689,519 shares of Visa, 3,731,426 shares of United Health Care, and 22,133,341 shares of Pfizer along with holdings in many other Dow Jones Index member securities. In the United States, Blackrock buys fixed income ETFs on behalf of the US Treasury with money supplied by the Fed through special purpose entities.
Continuous and indiscriminate central bank asset purchases distort financial markets because central banks are infinite players, whereas, individual investors have finite lives. Simon Sinek addresses Game Theory and the quagmire that results when infinite players play against finite players in this Google talk:
Freeing Ourselves from the Quagmire of Central Planning
Interestingly, with the development of cryptocurrencies, Defi, and token economics, the free market may have also turned Central Banks into finite players. The nominal prices for cryptocurrencies and gold are determined based on their supply and demand characteristics relative to the supply and demand characteristics of fiat currencies. If we assume, for the simplicity of illustration, that a particular cryptocurrency and fiat currency pair (say Bitcon – BTC to the U.S. Dollar) has a constant demand function, then the price appreciation or depreciation of BTC/USD would be solely driven by the growth in the supply of BTC relative to the growth in supply of USD. Therefore, interest rates differentials should either encourage more or less BTC production relative to a particular fiat currency. Given that the supply growth of BTC is smaller than the supply growth of USD, and the interest rate differential remains in favor of BTC, one would expect BTC to appreciate relative to the USD.
Estimating the Size of the Asset Price Inflation Monetary Gap
We estimate the asset price inflation monetary gap has created a mispricing of approximately 175-200 basis points (1.75-2.0%) across markets. We derived this estimate from two methods. First, we analyzed the relationship between short-term interest rates and various measures of inflation since the Federal Reserve’s inception. We would point out that while these measures have occasionally diverged, they tracked relatively closely until we entered the quantitative easing era. Today, the 10-year realized inflation rate by the Fed’s own measure stands at 1.82% v. an overnight rate of 8 bps for a difference of 1.74%.
The second method we used to estimate the asset price inflation monetary gap involved comparing short-term interest rates to staking rates for the two largest cryptocurrencies. If the supply growth of BTC relative to the supply growth of USD is lower, then we would expect an increasing price for a constant demand function. As a result, a higher interest rate on BTC relative to USD will discourage relative production. Thus, buying BTC and staking might be thought of as a form of an inflation protected bond with a volatile demand function.
Converting Equity Values into Real Prices
Historically, nominal to real price adjustments were straightforward. Consumer price goods baskets were relatively uniform, and other stores of value like gold and commodities had direct links to the industrial economy. Equity values were reflected in the share prices of the companies in the Dow Jones Industrial and Dow Jones Transportation Averages. The transition from an Industrial Economy to a Digital and Information Economy, however, created a gap that made real price measurement adjustments difficult. Software businesses like Microsoft simply do not need the same amounts of tangible property, plant, and equipment as industrial companies in order to drive business value. Fortunately, the universe created cryptocurrencies and thereby provided the modern analyst an additional tool for measuring real values. I believe real price estimates can now be obtained from nominal prices by conversions into gold for tangible assets and conversions into bitcoin for the goodwill, patents, trademark, network values, and other intangible assets associated with technology and service businesses.
Bitcoin, Gold Dow Theory Framework
Under my BGDT Framework, first published in 2017, I postulated that the value of one gold coin, plus one bitcoin, will approximate the value of one Dow share over time. This has largely proven correct to this point in time. In this framework, tangible book values and centrally directed interest rates are easily measured and change infrequently. Meanwhile intangible values like patents, trademarks, network effects, and inflationary values of more difficult to accurately price. Logically this suggests that the volatility of gold should be lower than the volatility of equities, the volatility of cryptocurrencies would be higher than equities, and the volatility of equities would reflect a blended volatility based on the ratio of tangible to intangible values of the businesses. A fourth factor in all asset values would be the asset price inflation monetary gap. Finally, the analyst must make a determination as to the appropriate discount rates to use.
Does this type of analysis work?
I will let the reader decide for his or herself, but I would point out that my analysis has correctly identified two technical points of resistance for the Dow Jones Industrial index, one technical point of support for the stock Index, and has correctly identified the most undervalued asset classes consistently. I began this real time experiment 7 years ago and have posted all reports on Bloomberg. The following is a performance table since our 2020 report and my prior recommendations chart with both my high and low recommendations charted since 2015.
|Gold (GLD etf)
Dow Jones Average ETF (DIA)
Source: Bloomberg and FinTrust
What Policy Now? – A Top Down Look
“Much like last year’s analysis, the current low levels of dividend and earnings yields and interest rates suggest a fair degree of caution. For the 52 weeks ending December 17, 2021 Barron’s reports the 12-month trailing earnings for the Dow 30 components at $1,602.94 v. $1023.05 for the prior year, paid dividends of $629.70, and an equity book decline to $6,543 from $6,688. Based on an earnings retention rate of 60.7% and a return on average equity of 24.23%, the implied expected book value growth for the next year would be a solid 14.71%, which when added to an initial 1.75% dividend yield would lead to an expected 16.46% total return under average conditions. While impressive and consistent with historical ranges, I point out that earnings margins are not likely to stay elevated under inflationary conditions and interest rates remain severely depressed at a time when corporate and government debts are high and currency values are in flux.
In expanding this analysis to the broader S&P 500 index, using data for book value, return on equity, dividends and earnings returns, one finds that the S&P 500 companies experienced an earnings recovery with earnings rising to $158.75 from $99.23. Likewise, dividends rose on a year over year basis to $61.91 v. the prior year’s $57.40. Meanwhile, average equity for the S&P 500 was $921 for the trailing 12 months, which when combined with the 61% earnings retention rate yields an expectation for book value growth of 10.51%. This 10.51% growth when added to the initial 1.36% yield leads to a total return expectation of 11.87% for the next twelve months.
Given that our interest is in determining portfolio policy for the defensive investor, I have previously suggested a few modifications to Mr. Graham’s methods. First, in order to stress test the analysis, I have suggested deflating current profits by 1/3 for a normalization of interest rates. Estimating the degree of interest rate distortion has been a guessing game, but the developments in Defi and cryptocurrency staking markets have added clarity to the task.
These free-market staking rates can be viewed here.
The marketcap of cryptocurrencies as of January 24, 2021 stands at $1.63 Trillion according to Coinmarketcap.com and Bitcoin has the largest market capitalization at $684 billion. Given the limited supply features of Bitcoin, Bitcoin inherently provides fiat currency inflation protection, thus the BTC staking rate may be considered a real rate of interest. As BTC is considered good collateral on cryptocurrency exchanges, it may be considered a real short-term rate of interest. Thus, the BTC staking yield plus the inflation rate suggests central banks are underpricing interest rates by nearly 2.0%.
Finally, I also suggest adjusting the return expectations by the one-year probability of a down year in stocks (35.65% for the 115 years from 1901-2016).
What portfolio policy then for the “defensive” investor?
It must be evident to the reader that I continue to find the stocks of the Dow Jones Industrial Average at today’s prices look better on average than taxable bonds given the spread between the expected total return on equities (16.46% and 11.87%% for the Dow and S&P) versus the (2.25%) yield on taxable bonds. I am more confident in the analysis now that earnings have declined to recessionary lows in 2020, but I remain concerned in my analysis given the suppressed nature of global interest rates, as both equities and bonds may be mispriced. Despite trading near the midpoint of my estimated range, the case for equities at today’s prices is still not so compelling when compared to high quality bonds and alternatives, as to lead a defensive investor to completely abandon balanced asset allocations in the search of a little more growth and income.
Portfolio Policy – A Bottom’s Up Look
In discussing common stock selection for the defensive investor, Graham suggests the following:
- Adequate though not excessive diversification, meaning a minimum of ten to a maximum of about 30 stocks.
- Limit selections to large prominent and conservatively financed corporations.
- Each company should have a long record of continuous dividends.
- An investor should place a limit on the price he will pay in relation to average earnings over say the past 7 years.
Later, in The Intelligent Investor, Graham figures that estimates for a group of equities are likely to be a good deal more dependable than those for individual companies and he uses data from Value Line to illustrate his point. The outcome of this effort, in 1965, found that while earnings estimates proved to be high, and many wrong, the use of low multipliers on earnings led reasonable results for a portfolio of equities over the following five years.
In an effort to produce an analysis similar to Prof. Graham, I once again took the Dow 30 Components, a diverse set of 30 prominent and conservatively financed corporations. I then calculated the average ratios of price to sales, price to earnings, dividend yields, and price to book value for at least the previous 14 years (2007-2021), if available, in order to capture the period both before and after the global financial crisis and the Covid shutdown related recession. Then using both the annual high and annual low for the stock price, I calculated the corresponding price to sales, price to book, price to earnings and dividend yields and averaged these for each security across various trailing time periods. I further applied these average ratios to the forward estimates from Value Line and MarketSmith and FinTrust estimates for each respective variable to develop price range estimates for each of Dow Components.
What portfolio policy then for the “defensive” investor?
As Mr. Graham cautions, the valuations reached by the method above are unlikely to prove sufficiently dependable, particularly on an individual company level, so an investor must endeavor to pay a low-prices in relation to average earnings. This suggests prices below 32,379 on the Dow Jones Industrial Average would appear reasonable, while prices above 39,046 would appear to be too high for the defensive investor. Prices close to 25,713 would be low in relation to past multiples.
My analysis suggests levels below 32,379 on the Dow Jones Industrial Average would be below the 10-year average, and levels closer to 25,713 would represent low prices relative to the average results, while an index level of 39,046 would be considered rich in relation to past sales, earnings, book value, dividends and forward analyst estimates. The data suggest that for the “defensive investor” reasonable allocations toward common stocks at today’s levels appear appropriate and reasonable. Given the components of the Dow 30 collectively appear to trade at slightly above average levels (36,338 v. 32,379 or 112.2% of average), portfolio policy for the “defensive investor” should lean toward average equity allocations (so if one normally splits funds in a 50/50 ratio, the analysis suggests a 45/55 ratio).
Risks to the Recommendation:
With the benefit of hindsight, Mr. Graham recognized in later editions that he underestimated the risks associated with bonds in 1965, as future inflation proved quite devastating to bond portfolios in the 1970s. Interestingly, today’s data points certainly still look similar to those of Mr. Graham’s 1965 edition. No one, in 1965, anticipated the high inflation rate of the 1970s and the impact it was to have on both the earnings of corporations and bond portfolios. I believe that the next large inflation could be digital in nature, as millennial investors may prefer uploading excess money to non-fiat currencies in the cloud with their phones verse the complications associated with investing in gold, real estate, and other fixed or tangible assets. In addition to unanticipated inflation, other risks to the recommendation include, but are not limit to, regulatory, governmental, and tax law changes, political risks, the mere fact the future is uncertain, and all other risks normally associated with investments in common equities.
The table below contains the range estimates for the individual securities in the Dow Jones Industrial Index.
|The Boeing Company
|Cisco Systems Inc.
|The Walt Disney Company
|The Goldman Sachs Group
|The Home Depot, Inc.
|Honeywell International Inc.
|International Business Machines
|Johnson & Johnson
|JPMorgan Chase & Co.
|The Coca-Cola Company
|Merk & Co. Inc.
|The Proctor & Gamble Company
|The Travelers Companies, Inc.
|United Health Group Incorporated
|Verizon Communications Inc.
|Walgreens Boots Alliance Inc.
|Wal-Mart Stores Inc.
Source: Value Line, MarketSmith, and FinTrust estimates
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An analyst or a member of his household may not purchase the securities of a subject company 30 days before or 5 days after the issuance of the research analyst’s report or a change in ratings or price targets, trade inconsistent with the views expressed by the research analyst, and all transactions in the subject company (ies) securities for the research analyst’s personal trading account must be approved.
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