Is the Dow Jones overpriced?

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It's been a long time coming, but one of the ghosts of the dotcom bubble may be on the verge of being exorcised. The Dow Jones Industrial Average is within a couple of good trading sessions of its all-time high of 11,730, set back in January 2000.

Although MoneyWeek is generally pretty bearish on Western equity markets, I think that the Dow's recovery from a low of less than 7,500 in late 2002 is not totally undeserved. Its price/earnings ratio of 22 times may look fairly steep, but on forecast earnings that shrinks to about 15 times. Since the index consists of large, mostly high-quality companies with decent earnings visibility, pricing in some of those earnings gains before they actually arrive is by no means a mistake.

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Nevertheless, the Dow trades on a high rating compared with the S&P500 (trailing p/e of 17.5, forward p/e of 15). And it certainly looks pricey compared with the FTSE 100 (trailing p/e of 15.5, forward p/e of 12), even allowing for the fact that the UK always keeps a discount to the US.

At first glance, this suggests it might have the most to lose in the looming US slowdown. But that's probably not the case

Many of the firms in the Dow offer good protection in the event of a downturn: some are in classic defensive sectors such consumer staples or pharmaceuticals; others such as the telecom companies pay decent yields. Even those whose earnings will suffer are still blue-chip names and may perversely attract investment as part of the flight-to-quality' that always accompanies times of trouble. Only embattled carmaker GM really looks like a sell at present.

But what of the S&P 500? Both it and the Dow are on roughly the same forward p/e, but the S&P's trailing p/e is much lower than the Dow's. That suggests that there's rather less room for disappointment if the S&P's earnings turn out worse than expected.

However, that overlooks the less-reliable nature of the S&P's earnings. As Richard Bernstein at Merrill Lynch points out, the proportion of S&P 500 companies that are lower quality in terms of creditworthiness (ie have a Standard & Poor's common stock ranking of B or lower) has been growing in recent years and now accounts for around 50% of the index.

By definition, lower-quality companies have less predictable earnings streams. So it's much riskier to value them on a forward p/e, because of the potential of unpleasant surprises on earnings.

So, despite the Dow's higher current rating, I'm inclined to think that it looks better value than the S&P given the economic outlook.

And what about the FTSE 100? Well, simply on ratings, it looks the best of the three. A forward p/e of 12 sounds extremely attractive for an index that is traditionally regarded as a good defensive play.

But today's Footsie is a bit of a strange beast. Historically, we've tended to think of it as an index heavily-weighted towards blue-chips. But the composition has changed greatly in recent years; there's a lot of cyclical plays, plenty of firms geared to the property market and quite a number who simply haven't been around long enough to be considered anything like blue-chip. And many of the classic defensive stocks within the Footsie, such as utilities, look expensive by historical standards.

On the other hand, a few stocks still seem like good value. Most notable are the oil majors, BP and Shell. Even though oil is a cyclical play, the present supply-demand outlook should ensure oil prices stay high for longer than usual this time. And BP and Shell look more attractive on valuation grounds than ExxonMobil, the oil component of the Dow.

On balance, I'd expect the Dow to hold up best of the three indices if we head into a US-led slowdown. But I don't think that buying indices is likely to be a particularly attractive strategy in the environment we seem to be heading into. The slowdown could result in the kind of side-to-side or mildly-falling market where the best chance of a decent return is a sector with underrated fundamentals (maybe oil) or picking up individual defensives that are still undervalued (perhaps National Grid).

Of course, if the slowdown turns into a severe recession, as some of the US housing market data suggests it might, then all bets are off. That might well leave us in the type of bear run where to twist a phrase a falling tide beaches all ships. In those circumstances, cash becomes the investor's best friend.

Turning to the markets...

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The FTSE 100 closed flat at 5,877 on Friday, as gains amongst mortgage banking stocks were offset by further woes in the online gambling sector. HBOS, Prudential and Northern Rock were among the day's highest climbers, lifted by strong broker comment and expectations of further interest rate hikes. Online gaming stocks were led into the red by blue chip Partygaming, with small-caps 888 and Sportingbet also lower, after shares in Vienna-listed online gambler BWin were suspended. For a full market report, see: London market close

Elsewhere in Europe, the CAC-40 closed 21 points higher, at 5144, buoyed by the gains on Wall Street. The Frankfurt DAX-30 closed at 5,937.

Across the Atlantic, stocks ended the day higher after moderate consumer inflation data boosted sentiment. The Dow Jones Industrial Average was 33 points higher, at 11,560. The S&P 500 closed at 1,319, up 3 points. And the tech-heavy Nasdaq ended the day 6 points higher, at 2,235.

In Asia, the Nikkei is closed for a holiday today. However, the Hang Seng was boosted by Friday's gains on Wall Street, closing 149 points higher at 17,387.

The price of crude oil was on the up again this morning, last trading at $63.65 in New York. In London, Brent spot was trading $61.97.

Spot gold was trading at $582.70 this morning, having bounced back from Friday's lows.

And in London this morning, property website Rightmove announced that asking prices rose 10% on last year in the period from mid-August to early September, suggesting that last month's interest rate hike had had little effect. However, the figures are based only on initial asking prices. The number of properties coming on to the market was at itslowest level since the start of the year.

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