The Wall Street Waltz: 90 Visual Perspectives, Illustrated Lessons From Financial Cycles and Trends, Revised and Updated Edition

Chart 6

Price-to-Book Ratios: Playing It by the Book

Can the Dow Jones Industrials, as some writers suggest, soon hit 3,000? It's possible, but historic valuations say it's unlikely. Proponents predict that prices will triple from the 1982 1,000-plus level because stocks more than tripled in other major bull markets such as the 1920s and 1950s. These analysts cite internal fundamentals: Earnings and dividends doubled since the mid-1960s, but the market remained in a 20-year trading range between 700 and 1,000—presumably prices got too cheap, particularly adjusting for inflation. Fans of the idea note that rising earnings raised book values too—through retained earnings plowed back into the businesses. Supposedly these rising book values (i.e., shareholders' equity, or the value of assets minus all liabilities) understate the Dow's real value, since accounting shows assets at their cost rather than their value after inflation. So, inflation should build pent-up pressure for a big boom.

But slow down. This chart shows the Dow divided by its prior year's book value—commonly known as the price-to-book ratio. Most bull markets start from low price-to-book ratios. The great bull market since 1982 started from an exceptionally low 1.10 price-to-book ratio. Since 1934, the Dow fell as low as book value only once, in 1979. In early 1987, the Dow's price-to-book was historically high—2.02—close to the 52-year high of 2.36 reached in 1965. This says there is little upside room left.

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