Dow 20,000 Not Far Off

Thursday, September 09, 2010

I suppose it depends on how you define not far off but I believe that over the next decade the market will rally to 20,000 without much trouble. With the Dow trading just over 10,000 and memories of the Panic of 2008 still very much reticent in investors' minds, a call for a doubling of the Dow, much less even new all-time highs in the forseeable future, is seemingly a radical belief to hold.

It's not crazy, it's only a 7% CAGR and don't forget the Internet

A call for 20,000 by 2020 amounts to a required compound annual growth rate of 7%. Believing this can happen is far from unreasonable. Say we see El-Erian's "New Normal" and the economy muddles along at 2-3% growth for the next decade as we undergo "deleveraging, reregulation and deglobalization". Even assuming this case it makes sense for the Dow to appreciate at a higher rate given that its composed of 30 of America's top companies. The best handful of American companies should be able to safety capture 6-8% equity growth especially considering many of them have substantial international exposures, particularly to emerging markets where growth is still red hot.

Yet, a forecast of 2-3% economic growth seems to vastly underestimate America's future prospects over the ten years. Investors have too easily forgotten what has happened in the last 20 years and the wide-ranging, never-before-imagined impacts one particular invention will create. Namely, the Internet. The Internet is in its infancy. We have not even scratched the surface on the incredible efficiencies and innovations that can and will be achieved. The eventual impacts of the Internet on our everyday lives will be like the ground-breaking changes electricity brought to our lives. Electricity fundamentally changed the way we live, the Internet has already done the same.

Technology adoption rate has been dramatically shortened

Throughout human history the path of innovation proliferation has typically followed a S-curve. From invention, new innovations take a significant amount of time to gain acceptance by what is termed a critical mass of adopters. Once a product reaches its required critical mass, the adoption rate dramatically spikes as exponentially more consumers purchase the product. Eventually, the innovation reaches a saturation point where demand stabilizes and the product matures. These innovation S-curves can be traced back over the last century and measured for their durations as the chart below shows.

The table below shows the incredible rapidity with which today's innovations are adopted by the general public. While electricity was invented in 1873, it took 46 years for a quarter of the American population to adopt it. Fast forward 100 years and the PC was invented in 1975 yet only took 16 years to reach a 25% of Americans. Even more amazing is the internet, invented in 1991 and adopted by a quarter of the population in just seven years!

Facebook and cloud computing

Facebook is an example too incredible not to discuss. The company was founded just six years ago in February 2004. Yet, Facebook now has over 500 million members and boasts a multi-billion dollar valuation on Second Market. Achieving that rate of adoption by a new technology is absolutely unprecedented in a historical context. The management of personal and business relationships has been entirely transformed in just the last several years through the rise of online social networking.

Cloud computing is a new wave of the future and many have yet to recognize how it will revolutionize everyday business. Google Docs is a simple example. You can now start a spreadsheet, share it with some friends, and all join in simultaneously working on it each from your own personal computer from any location around the world. The efficiencies that will be achieved with just this simple concept are enormous.

Tech boom buyers were right

The 1990s bubble in technology stocks was based on an overly optimistic timeframe for what the Internet could accomplish. It was not Tulipmania of the 1600s resulting from the 'greater fool' theory where buyers assumed that even if the investment was questionable, there would always be a greater fool to buy at a higher price. Nor was it like the much more recent oil or real estate bubbles built on expectations of higher and higher demand for something relatively fixed, crude oil and houses. To be sure, there were definitely those late in the game operating under Burton Malkiel's "castles in the air" philosophy not thinking about the underlying fundamentals of the businesses. But, many of the buyers of technology stocks believed the world would be fundamentally changed by the PC and the Internet...and they were right!

What will the next decade bring? Maybe we should first ask: what will the next year bring? Innovation is occurring at an astounding pace and while buyers of technology stocks in the late 1990s were absurdly optimistic on how fast the innovations stemming from the Internet would come on line, they were not irrational to believe in the world-changing power of the computer and Internet. Add all this together and Dow 20,000 may just be a conservative bet!

Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: Long SPY but professionally I am a long/short active trader. This position is subject to change many, many times in the next decade. Perhaps this lends me credibility because I am not just touting my built-in professional bias but sharing what I believe is a very realistic outlook amid a swath of investor pessimism.
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