Dow Jones breaches 22000 where to from here

Matthew Peter, Chief Economist

This week, the Dow Jones Industrial Average exceeded 22,000 for the first time in its 100-year-plus history. The break comes following a 23% surge in the index following the election of President Trump. More recently it has been the prospect of robust global growth and company earnings that has driven the rally, as the Trump-effect has faded. Reinforcing the brighter growth and earnings outlook has been a weak inflation environment that has moderated the market’s expectations of rises in interest rates.

The remarkable run of the US equity market has many analysts questioning underlying valuations of US equities and the extent to which a reversal of monetary stimulus will undermine current valuations. A simple valuation metric used by many equity analysts is the price to earnings (PE) ratio. This ratio shows the multiple of a company’s share price to the company’s per-share earnings.

Because the S&P 500 index is weighted by market capitalisation rather than company share prices, as is the case of the Dow Jones index, investors tend to concentrate on the S&P 500 index rather than the Dow Jones. For this reason, the following comments will be based on the S&P 500 index rather than the Dow Jones, although the two indexes movements are very closely correlated.

The PE ratio finds favour as a valuation signal because of its apparent mean-reverting behaviour over history. What this means is that periods of high levels of the PE ratio (relative to history), tend to be followed by corrections (i.e., falls in equity prices) that return the PE ratio back towards its historical average. Hence, high levels of the PE ratio relative to its historical mean tend to foretell declines in equity prices, while low PE levels tend to foretell rises in equity prices.

Of course, the level of the PE ratio, at any given point in time, is a function of the level of the equity prices and the level of the companies’ earnings per share. Although many different schools of thought exist on which measure of company earnings is the most appropriate, most analysts tend to use a one-year forward earnings estimate. Given today’s equity prices and forward earnings estimates, the S&P 500 index is currently trading at a PE multiple of around 19. This compares to an historical average PE ratio of around 15.

Currently, the one year forward earnings estimate for the S&P 500 is $124 per share and the S&P 500 index has averaged around 2370 over the month of July. Hence, at current forward earnings’ levels, a reversion of the S&P 500’s PE ratio to its historical average of 15 would imply around a 15% fall in the US equity market. While not signalling a bear market (-20%), the implied equity market correction is significant with only the European debt crisis induced correction being larger since the collapse of the equity market during the period of the GFC (from mid 2007 to mid 2009) when the S&P 500 fell by around 60%.

Is a 15% correction in the US equity market imminent? Many investors worry about the ability of equities to maintain current valuations in the face of rising interest rates. Higher (lower) interest rates raise (lower) the discount factor applied to company earnings in the calculation of enterprise value. Therefore, higher (lower) interest rates, lower (raise) a company’s share price for a given level of company earnings.

Implicit in the historical average estimate of the S&P 500 PE ratio is an average level of the real interest rate (i.e., the nominal interest rate adjusted for inflation) of around 3%, based on 10-year real bond yields over the period from 1986 to 2006. Assuming an equity risk premium of around 4%, a real interest rate of 3% gives an earnings yield of around 7% (i.e., 3% + 4%) or a PE multiple of 15 (i.e., 1/0.07).

However, given that the US and global economies have entered a low growth/low interest rate environment relative to the pre-GFC era, it is accepted that interest rates are unlikely to return to their pre-GFC levels. QIC’s estimate for the longer run level of the real US 10-year bond yield is just below 2%; a little higher than the Fed’s implied estimate of just above 1.5%.

Using QIC’s real 10-year bond yield to re-estimate the likely average PE multiple over coming years gives a value of just over 17; compared to the historical average of 15. This represents a misevaluation of around 7%, about half the implied correction required to return the PE ratio to its historical average. Consequently, while we expect some correction in US equity markets from their current levels, we do not expect there to be a severe correction.

Table 1: Financial market movements, 27 July – 03 August 2017Table 1: Financial market movements, 27 July – 03 August 2017

Equity index



10-yr government bond



Foreign exchange



S&P 500





-8.9 bps

US Dollar Index (DXY)



Nikkei 225





-0.4 bps




FTSE 100





-5.4 bps









-8.3 bps




S&P/ASX 200





-2.4 bps




Source: Bloomberg

Economic Update

United States

GDP growth recovers in the US with a rebound in consumption
  • The US economy grew at an annualised rate of 2.6% over the June quarter, up significantly from a revised GDP growth rate of 1.2% in Q1. This strong result (the 2nd highest in two years) was driven by an acceleration in personal consumption, business investment, exports, and federal government spending. Meanwhile, private residential investment and imports weighed down on growth over the quarter. 
  • Nominal personal consumption grew by 0.1% over the month of June (unchanged in real terms), down from 0.2% in May. This coincided with a deceleration in personal income which was unchanged over the month, down from 0.3% in May. The slowdown in personal income was driven by a reduction in interest and dividend income on the back of a particularly strong spike in April. 
  • Recent data suggests a slight moderation in business conditions in the US, with the ISM manufacturing index coming in at 56.3 in July, down from 57.8 in June. The ISM non-manufacturing index also decreased to 53.9 in July, down from 57.4 in June, with employment, business orders and new orders all decelerating.

Weekly Economic Brief

Weekly Economic Brief

Euro area / United Kingdom

GDP growth accelerates in the euro area
  • Preliminary estimates of euro area real GDP growth revealed a 0.6% expansion over the June quarter. Relative to the corresponding quarter of the previous year, the euro area economy expanded by 2.1%, the highest since 2011. 
  • Labour market conditions within the euro area continue to improve, with the unemployment rate decreasing to 9.1% in June, down from 9.2% in May. The improvement has been broad-based, including a notable decline in unemployment in Spain, Portugal, Greece and Italy during 2017. However, conditions continued to disappoint in France, where the unemployment rate has remained relatively unchanged over the calendar year.
  • Improving labour market conditions continue to support consumer spending in the region, with retail sales volumes rising 0.5% in June. Over the quarter, retail sales advanced 0.9%, the strongest gain seen in two years.  
  • The flash estimates for euro area headline inflation remained unchanged at 1.3% over July. Meanwhile, core inflation (excluding energy, food, alcohol and tobacco) picked up to 1.2% in July from 1.1% in June. 

Weekly Economic Brief

Weekly Economic Brief

Weekly Economic Brief

China / Japan

Positive signs continue from manufacturing surveys in China
  • Chinese PMI data suggests that manufacturing has continued its recent strength into July after a robust Q2. After increasing to 51.7 in June, the official NBS manufacturing PMI fell a little to 51.4 in July, but still indicates ongoing expansion in the manufacturing sector. This is consistent with the Caixin-Markit manufacturing PMI, which rose to 51.1 in July despite the market expecting little change from June’s reading of 50.4 following a jump from 49.6 in May. 

Weekly Economic Brief

Australia / New Zealand

RBA leaves cash rate unchanged, though high dollar weighs on growth forecast
  • As widely expected, the RBA left the official cash rate unchanged at 1.5% at its Board meeting this week. While a bright outlook for the domestic economy was again a factor in the RBA’s policy stance, the strong AUD has emerged as a renewed obstacle. After noting in previous statements that an appreciating exchange rate would complicate Australia’s economic adjustment, the RBA’s language this month changed in response to the appreciating AUD (the AUD/USD and TWI appreciated 5.3% and 3.5% respectively between the dates of the two meetings), now recognising that “an appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast”.
  • Following recent strength in the AUD (on both a AUD/USD and TWI basis), the RBA today revised down their growth forecasts slightly, with expected year-average GDP growth in 2017 and 2018 revised down 25bps compared to their May forecasts.
  • Dwelling approvals bounced back in June, growing by 10.9% after falling in May. Approvals of houses and non-houses both grew in the month, and while both measures are lower than a year earlier, the year-ended decline has narrowed significantly from previous months. In another sign of a resilient housing market, CoreLogic data showed that year-ended growth in house prices reaccelerated in July to 10.5%, led by strong gains in Melbourne (+15.9% y/y) and Sydney (+12.4% y/y). 
  • Growth in housing credit remained little changed in year-ended terms in June, though monthly growth in investor housing credit has fallen for 6th consecutive month, showing that APRA’s macroprudential measures and resulting increases in investor mortgage rates are having an effect.
  • Retail trade data was a little stronger than expected in June as well as in the more detailed Q2 data. In values terms, retail sales grew by 0.3% in June, a slight moderation from the strong gains seen in April and May. Over the quarter, retail sales volumes jumped 1.5%, a much higher rate of quarterly growth than in previous quarters. Household goods retailing has been the main driver of growth in retail sales values and volumes over the June quarter.

Weekly Economic Brief

Weekly Economic Brief

Weekly Economic Brief

Weekly Economic Brief

Sources: Thomson Reuters, Bloomberg, FactSet, ABS.

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