5 Reasons Dow 20,000 Could Be Short-Lived (and Why It Doesn't Matter)
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Think about this for a moment: In March 2009, the Dow Jones Industrial Average (DJINDICES: ^DJI) was struggling to hold 6,500, and the U.S. economy was in nothing short of a freefall. Today, less than eight years later, the Dow, America's most iconic stock market index, is knocking on the door of 20,000. As of Wednesday's close, the oldest major U.S. index sat just 58 points away from hitting a highly anticipated milestone.
For investors, Dow 20,000 represents a number of things. First, it's validation that the U.S. economy is finally back on track and standing on its own two feet following the Great Recession. Second, it's confirmation that investors still believe in the seven-plus-year bull market rally, even after the Dow has doubled in value. And finally, it's a reward for long-term investors who've stuck with their investments throughout the market's ups and downs.
Dow 20,000 (should it hit) could be short-lived
However, there are also reasons to believe that Dow 20,000, should the Dow even hit this heralded milestone, could be short-lived. Here's why optimists could be in for a rude awakening should the Dow hit 20,000.
1. The Trump factor
Arguably the biggest wild card for the Dow and stocks in general is President-elect Donald Trump. He's set to enter the Oval Office in less than a month and is the first incoming president to have no political or military experience. Long story short, there's concern and uncertainty that Trump could be unprepared for the magnitude of the task at hand.
Image source: Evan Guest, Flickr.
In particular, Wall Street and investors are interested in Trump's income tax proposals for individuals and corporations. Even though Trump's individual income-tax proposal of three simplified tax brackets (12%, 25%, and 33%) was taken from the Republican House, and the legislative branch of government is a Republican majority, there are few guarantees that Trump will be able to execute on his campaign promises. The concern is that Wall Street has already begun pricing lower corporate tax rates Trump has proposed lowering corporate income tax rates to 15% from 35% -- into company valuations. If there's any hold-up in enacting Trump's tax policies, the Dow could rapidly lose steam.
Similarly, but without going into too much detail, Trump's plan to repeal and replace Obamacare, along with his desire to renegotiate trade deals, could raise market uncertainty and adversely affect the Dow.
2. The Federal Reserve
The Federal Reserve could also wind up being a source of the Dow's undoing.
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For years, the Fed has kept its federal funds target rate at or near historic lows. While the Fed doesn't directly control the interest rates you pay via a mortgage or credit card, it does maintain influence through its federal funds target rate. By keeping its federal funds target near historic lows, it's allowed consumers to buy homes with very low mortgage rates, and it's brought consumers' credit card interest rates down, enticing them to spend.
However, it's also plausible that the Fed has spoiled the consumer after eight years of exceptionally low interest rates. As someone who once worked in retail, I distinctly remember how 50%-off sales lost their luster over time, and the consumer simply waited on a better deal before buying goods. It's quite possible we could see the same thing with U.S. consumers as the Fed looks to keep a lid on inflation by raising its benchmark rate. This could lead to a weaker housing market and a more cautious consumer.
3. China
Another way Dow 20,000 could be derailed has to do with China. After growing GDP at roughly 10% over the past three decades, China's GDP growth rate has fallen to between 6% and 7%. For nearly any country the size of China, 6%-plus GDP growth would seem like a dream come true. But China's slowing growth is a big problem for the rest of the world, including the United States.
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China is a monster in the consumption department, and during the Great Recession it wound up playing a key role in propping up the U.S. economy with its demand. However, with China's own economic growth slowing, its demand for goods has slowed, too. From commodities such as copper and electronic devices, to bigger products such as automobiles, China's trade partners in the U.S., South Korea, Japan, and Germany have felt the impact. If China's GDP continues to slow, it could have an adverse impact on the Dow and U.S. stocks in general.
4. Brexit
Britain's impending exit from the European Union, known as "Brexit," could also throw the Dow for a loop.
The EU Referendum that saw Britain's residents vote in favor of leaving the EU was a big shock to the world because the polls leading up the vote had suggested the remain campaign was in the lead. Despite an initial global shock following the decision, global stock markets have rebounded in a big way. However, it doesn't mean this is the last we've heard of Brexit.
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No country has ever invoked Article 50 before and left the European Union, so there really is no precedent or point of reference for Wall Street to point to. Furthermore, Britain wound up losing its highly coveted AAA credit rating, meaning its borrowing costs will be higher, and a plunge in the British pound is making it more expensive for British firms to do business in Europe. The U.K. is a critical cog to global financial stability, but it remains possible that Brexit could push it, and Europe, into a recession.
5. U.S. stock valuations
Finally, Wall Street pundits could wind up sacking Dow 20,000 based solely on stock valuations.
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According to Robert Shiller's P/E ratio calculations for the S&P 500 (SNPINDEX: ^GSPC), the current P/E ratio of the S&P 500 is 26.1. There have been only two other instances over the past 120 years where the S&P's P/E ratio eclipsed the 26 mark: before the dot-com boom, where it hit more than 40, and before the Great Recession. This could obviously be a coincidence and in no way guarantees that a stock market plunge is around the corner, but history would certainly suggest that stock valuations appear stretched based on Shiller's calculation, and that's a possible cause for concern.
Here's why you shouldn't be too concerned with the Dow's milestone
Despite these five very real causes for concern, Dow 20,000 isn't a reason for patient long-term investors to be worried.
Image source: Getty Images.
For starters, stock market corrections happen all the time. According to data from Yardeni Research, there have been 35 stock market corrections totaling 10% or more (when rounded to the nearest whole number) in the S&P 500 over the past 66 years. That's roughly one every two years. The interesting fact isn't that stocks correct quite often, but that bull-market rallies have erased every single stock market correction and bear market in the S&P 500's and Dow Jones' history. In other words, if investors simply stay the course and buy high-quality businesses, they should do just fine and make money over the long run.
Another point to consider that builds off the "stay-the-course" ethos is that the stock market has historically increased in value by roughly 7% per year, inclusive of dividend reinvestment. At a 7% annual rate of return, the Dow should be doubling in value about once every decade.
Regardless of whether the Dow hits 20,000 and continues to plow higher, hits 20,000 and falls back, or fails to eclipse 20,000 over the coming days or weeks, is of little consequence to long-term investors because we know that over long run the stock valuations of good companies tend to head higher.
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