August 16, 1998
A HISTORY LESSON 
For Major Indexes, A Long Way to Doom 



For years, both the returns generated by stocks and the valuations that investors assigned to them have vastly exceeded levels experienced throughout market history. Some argue that outsized valuations are simply a result of a new era of investing in which the old rules no longer apply. These folks are happy to pay 200 times earnings for America Online. 

For the rest of us here on planet Earth, a little dose of reality now comes from the market watchers at the Leuthold Group in Minneapolis. They have collected data back to 1926 on two indexes: the Dow Jones industrial average and the Standard & Poor's industrials (not the S&P 500-stock index). 

Let's begin with where we are now, based on two common measures: price-earnings ratios and average dividend yield, or the amount of dividends paid by the companies in the group divided by the total price of those companies' stocks. 

As of Friday, the Dow stood at 8,425. It carried a p/e ratio of 21, and dividends paid by the stocks in the Dow group yielded an average 1.75 percent. The S&P industrials closed the week at 1,252.60. Its price-earnings ratio was 29; its dividend yield, 1.35 percent. 

Over 72 years, the median p/e ratio on the Dow has been 15.3. How far off that median are we now? For the Dow to return to that valuation level, it would have to drop 37 percent, to 5,291. 

The median dividend yield on the Dow has historically been 4.3 percent, more than double what it is now. For dividend yield valuations to revert to their median, the Dow would have to fall to 3,353, or 60 percent below its Friday close. 

If the S&P industrials reverted to the historical norm as measured by p/e, this index would lose about half its value, falling to 634. If measured by dividend yield, the index would collapse to 445, a fall of 64 percent. 

Obviously, market experts don't think the averages will plunge to levels anywhere near their historical medians. And with most Americans certain that the stock market is the best place to put their money, continued demand for equities could keep their prices in the stratosphere. 

The Leuthold Group has compiled another set of numbers that goes back to 1957 and includes only those periods when inflation was low. If the Dow Jones industrials were to trade at the median p/e ratio during periods of low inflation, it would fall to 5,972, a decline of 29 percent. The S&P industrials would have to drop 37 percent, to 788. 

The old rules may indeed no longer apply to our brave new market. Still, it is better to know what history has to say than to ignore it. 

GRETCHEN MORGENSON