Monday, October 27, 2008

How low will the Dow go?

A frequent topic of conversation these days is the declining market. It is particularly interesting because so many people are affected by it, and certainly my own portfolio has taken a real bruising over the past year.

I told my broker my original thesis last March that the credit "issues" back then would have repercusions in the real earnings power of companies and bring down stock prices to the Dow 10,000 level. We made a lunch bet on it - I won that one. Now the question is how much further it will fall - or have we reached the bottom.

There are many pundits in the market today. They talk about the pressure of Hedge Funds, and the deleveraging of the credit market. I think about the habit of history repeating itself. Maybe not in the terms of the Great Depression - but possibly in the terms of the 1970's and early 80's. So I thought I would do a bit of research and share it...

First, I decided to look at the DJIA price 20 years ago and what the Inflation rate has been since then to get a feel for where things were at the end of the vaunted Reagan era when things had gotten back on track (the DJIA went from under 1,000 to over 2,500 during Reagan's 8 years in office). The DJIA on Oct. 3, 1988 was 2,168. Since then inflation has increased 75% as measured by the CPI, as it has gone from 118 to 207.

Let's assume stocks should return twice as much as inflation, then the stock market would be at 2168 * (1 + (.75 * 2)) = 5,420. Hmmm - that does not look so good, and could be an indicator that there is still significant downside in this market.

In another view, Price Earnings Ratios have been one of the standard ways to value stocks. Of course earnings calculations have been changed significantly over the years with issues like measuring the value of assets on and taking big write-offs (like Wachovia's recent -$24B write-off). But it is still useful.

The WSJ states that the past 12 month PE Ratio is now 13, which is "well below the 10-year average of about 21 times earnings". But the article goes on to say "But if the economy slides into a deep recession, as some predict, and earnings continue to slide, current stock prices won't look cheap."



Three observations. First, it is obvious that the next 12 months of earnings will fall significantly from the past 12 months. Second, in the recent earnings calls few executives are giving much guidance on future earnings and that will scare investors so they will not pay as much for a given earnings level. Third, the chart above shows many times when PE ratios were below 13. If history does indeed repeat itself, then we could see pressure on current prices. To take one set of non-far-fetched numbers earnings could fall by 20%, and PE ratios could continue to fall to the 10 range. This could drop prices by roughly 40%, implying a Dow of about 5,000 from the current 8,200.

I am a child of the 70's (graduated high school in 1975 as a semi Alex P. Keaton) and remember the Dow inching above 1,000 barely in 1972, 1976 and 1981 before it permantently stuck in 1982. Could we get into a similar situation of a stagnated Dow? While we are likely in for a recession for a year, there is a possible inflation scenario similar to the 70's that could follow given all of the money supply expansion worldwide and the likely government stimulous packages that will grow National debts across the globe.

OK, so I am pretty depressing. I am going to guess a Dow of 6,000 as the low. The good news is that if you are a long term investor and can free up cash over the next couple of years, this should prove to be a very good time to invest. Who knows where the bottom will be exactly. If you can dollar cost average your buying then it should be pretty effective when the positive side of history repeating itself occurs.

No comments: