Experts: Record-setting Dow is good news, but more for peace of mind

Specialist Frank Masiello wears a Dow 20,000 cap as he works on the floor of the New York Stock Exchange, Wednesday, Jan. 25, 2017. The Dow Jones industrial average is trading over 20,000 points for the first time, the latest milestone in a record-setting drive for the stock market. The market has been marching steadily higher since bottoming out in March 2009 in the aftermath of the financial crisis. (AP Photo/Richard Drew)

On Wednesday, the Dow Jones industrial average closed above 20,000 for the first time ever, rolling up the second-fastest thousand-point gain since the dot-com bubble of 1999. The Dow, which represents an average of 30 significant stocks traded on the New York Stock Exchange, is one of the most carefully-watched indicators of the state of the economy.

We asked two faculty experts—Jeffery A. Born, finance professor in the D’Amore-McKim School of Business, and William Dickens, University Distinguished Professor of Economics and Social Policy and chair of the Department of Economics—to provide some insight into the Dow’s historic high.

In your estimation, what factors led to this historic moment?

Born: I think there are three main things driving the Dow since the New Year: First, the Fed has not moved aggressively to raise interest rates; second, with some exceptions (e.g. brick and mortar retailers), fourth-quarter earnings announcements have been generally good; and third, investors are optimistic that President Trump will deliver on his promises to reduce taxes and regulations on the business sector while spending money on infrastructure.

Dickens: As long as the economy is growing, the Dow is going to go up. The recent surge in the Dow is likely driven by two things.

First, over the last several months it has become clear that the U.S. economy has finally returned to normal. The unemployment rate has dropped to low levels, new claims for unemployment insurance are at historic lows, job vacancy rates are up, wages are growing faster than inflation, and quit rates show that workers are again confident that they can find jobs. Labor force participation is still low compared to the 2000s, but that has been declining since the late 1990s when the growth in women’s labor force participation halted and other downward trends became dominant. Seeing this, the Fed has begun to return interest rates to a normal range. All this is making investors more confident and willing to invest in stocks.

A second factor seems to be a large growth in enthusiasm for financial stocks, as they have led the growth of the market. This could just be a reaction to the improved situation as noted above, or it could be due to the expected deregulation of financial firms allowing them to go back to the very profitable practices that they engaged in before the 2007 recession.

What does this mean for the average investor who, say, might only have a 401(k)?

Dickens: Everybody will gain more or less in proportion to the growth of broad market indices, which tend to move with the Dow.

Born: As a firm’s share price rises, its cost of using equity capital declines. This can cause the firm to undertake an investment project that it might have previously rejected. Investment in capital assets by firms not only can increase employment for that firm, but it can trigger a multiplier effect across other firms that supply it. So, there are some investors that might get new or better jobs as a result of rising stock prices in addition to having a healthier 401(k).

Greg McBride, chief financial analyst with Bankrate.com, told a Washington Post reporter, “The Dow hit 20,000. The Queen of England turned 90 last year. Both are round numbers. Neither carry any real significance.” To what extent is this an indicator of U.S. economic strength? In other words, how much is this a psychological milestone as opposed to a quantifiable milestone?

Born: When you have been an investor as long as I have (I started at age 13 in 1968), you have seen many of these milestones before (1,000; 5,000; 10,000; now 20,000). Each time there has been a bit of anticipation and anxiety, as if there was something magical about these big, round numbers. For the sophisticated investor, they’re not anything special. The Dow is more important psychologically than as a barometer of how well all business is doing.

Dickens: McBride got it mostly right. There is a type of investment analysis called technical analysis that holds that round numbers represent barriers and that once they are broken growth can proceed unconstrained for a bit. If this is true, the effects are very hard to detect.

Related to that, to what extent is it a “bubble,” or a “rally” based on hope in President Trump’s calls for massive infrastructure spending, less regulation, and tax cuts?

Dickens: It isn’t a bubble yet. One-year-ahead projections of firm earnings justify current stock prices, so the growth would seem to be on solid ground. Those projections probably do take into account some impact from tax cuts and increased government spending, but the economy is at or near full employment so the potential impact of fiscal policy at this point is limited and most forecasts probably take this into account. Even if fiscal policy does increase growth, the Fed is likely to increase interest rates faster to avoid overheating the economy and a resurgence of inflation.

Born: Investing in common stocks is risky—no matter what the level of the indexes are. When stock prices get significantly out of line with reasonable expectations about where the real economy is headed, there can be trouble (bubbles on the up-side, unjustified panics on the downside). From where I sit, I don’t see that the Dow is excessively over-valued, but I do think that a lot of “good news” has already been built into share prices. If the president is unable to deliver on his promises in a timely fashion, or if his spending programs and tax cuts spark an upsurge in inflation, we could see the Dow and other indexes retreat from their current levels.

Do you expect this will be a deciding factor in the Fed’s consideration of raising interest rates? If rates do go up, how much would that impact financial markets?

Born: I think that interest rates are a huge key. The Fed is committed to raising rates—how much and how fast is the question. If they rise sharply and quickly, we would see stock prices fall.