Is 20,000 a Floor or Ceiling for the Dow?

Much has been written of late regarding the Dow Jones industrial average 20,000 milestone and whether this will mark a near-term top of the market or perhaps the continuation of the eight-year bull market.

Some investors are posing this question because they're wondering if they should get completely out of the market now or stay in, lighten up exposure or make new investments. While history will tell us with certainty, there are prudent decisions which investors can make right now even without knowing the definitive answer.

[See: 10 Long-Term Investing Strategies That Work.]

First, what does Dow 20,000 even mean? To properly frame this discussion, it's important for investors to realize the stock market looks forward and not backward. Market prices generally reflect optimism or pessimism about the direction of future earnings. If investors think earnings of the underlying Dow 30 companies will rise, the share prices of these companies generally increase as well. Conversely, if investors anticipate a drop or slowdown in earnings, market prices typically drop.

Since the November elections, the market has rallied largely on optimism regarding President Donald Trump's growth initiatives -- tax and regulatory reform, infrastructure spending, etc. While index levels and big round numbers like 20,000 and 21,000 certainly catch headlines, valuation is more important when trying to decide if the stock market is truly expensive.

In other words, big numbers like Dow 20k need to be put into the larger context. After all, the 1,000 point move from 19,000 to 20,000 was a 5.26 percent increase, far different from the 9,000 to 10,000 increase (11.11 percent) in early 2009.

There are many different ways to gauge value in the stock market. One of the most commonly accepted valuation measures is the price-earnings ratio. Simply put, the P/E tells you how much you're paying today for $1 worth of earnings.

For example, the latest 12-month trailing (actual) earnings for the Dow 30 companies indicates a P/E of roughly 20 at current prices, which means investors are paying $20 for each $1 of earnings in the index. Why would investors pay this amount? It's because investors anticipate that these same Dow 30 companies are going to continue to grow earnings into the future. These investors are paying for the right to own this future earnings stream as a shareholder. As owners, they are hoping that the company will go up in value as the underlying earnings rise.

[See: 7 Ways to Tell if a Stock is a Good Price.]

Is $20 too much to pay for $1 of earnings? Although the answer is complicated, we do know that, through forward-earnings estimates, the Dow 30 has a P/E of roughly 16.5 today versus a historic average of about 15. Further, the Dow 30 forward-looking P/E has ranged from a low of 10.24 to a high of 22.23 over the past 25 years. So we are slightly above that midpoint but not dramatically so.

Taking our cue from history, we may reasonably believe that the Dow is slightly high but not sharply over-priced on a relative and historical basis (This is an observation of current conditions and not a suggestion to buy. Past performance is not an indicator of future performance.)

So what should an investor do today? If you have developed a financial plan and are contributing to your nest egg, continuing to dollar cost average into your investments still makes sense. You'll purchase fewer shares when prices go up and more shares when prices drop. Dollar cost averaging helps remove some of the emotion and timing guesswork by keeping you committed to a disciplined process. This is precisely what 401(k) investors are doing through their regular payroll deductions into their retirement plan.

Trying to be more opportunistic than this systematic approach? There's always a (relative) bull and bear market somewhere. Talk with your advisor about potential strategic changes to your portfolio to take advantage of this. Current prices might also permit you to prudently reduce risk.

If history provides a guide, we would expect the Dow 30 to trade around the 20,000 level for a while as it digests the rise in prices, lets earnings catch up or grow to expectation, and allows time for new presidential policies to become more clearly defined. Should earnings for the Dow companies continue to grow, look for 20,000 to be a floor, but should earnings stumble or drop in future quarters, it may turn out to be a ceiling. Either way, there are potentially prudent adjustments to be made to help your financial plan stay on track.

[See: 10 Questions to Ask Before You Hire a Financial Advisor.]

Information contained herein has been obtained by sources that D.A. Davidson & Co.'s Individual Investor Wealth Management Group considers reliable, but is not guaranteed and the company is not soliciting action based upon it. Any opinions expressed are those of the author and are based on interpretation of the data available at the time of the publication of this article. Investors should consult their financial and/or tax advisor before implementing any investment plan.

Andrew Crowell is a blogger for The Smarter Investor. He is vice chairman of D.A. Davidson & Co.'s Individual Investor Wealth Management Group and a third-generation financial advisor. He also sits on the board of directors for D.A. Davidson's parent company, D.A. Davidson Companies. For more information on D.A. Davidson's Wealth Management group visit the website or follow them on Twitter.