Posted by on Jul 13, 2010 in Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig | July 10, 2010  12:01 a.m. ET

Could the Dow really drop 90%?

Earlier this month, in an interview that was widely circulated online, market analyst Robert Prechter predicted that the Dow Jones Industrial Average will fall below 1000 within the next six years. The Dow promptly surged back above 10000, but it is worth asking whether Mr. Prechter might be right anyway.

The president of Elliott Wave International, a newsletter publisher and data service in Gainesville, Ga., Mr. Prechter isn’t the only pundit predicting a cataclysmic bear market. Richard Russell of Dow Theory Letters has called for a monstrous decline; through a spokeswoman, he declined to confirm a specific price target. Even money guru Robert Kiyosaki has gotten in on the act, conjecturing Dow 5000 in his online column.

Mr. Prechter is a technical analyst who studies the past price performance of the markets for clues to the future. He also believes that investors move in and out of the market on predictable waves of optimism and pessimism. “Because the mania [the bull markets of 1982 to 1999 and 2003 to 2007] was so terrific,” he told me this week, “it will be followed by a negative trend in social mood that will lead to a complete retracement.” That would put the Dow back to its levels in 1982, below 1000.

“In a deflationary environment, the last thing you want is to own any financial asset,” Mr. Prechter added. “If you stay out of stocks, real estate, gold and other commodities, which will all come down together, then you can preserve your purchasing power [in cash] for the next great buying opportunity.” He wouldn’t tell me what, if anything, he is selling short; he said only that he is “cash laden” with Treasury bills and Swiss money-market instruments.

But wouldn’t it be highly unusual for stocks to stagnate for 11 years and then collapse by 90%? “Definitely,” Mr. Prechter told me. “It’s very rare.” But, he points out, it is also very rare for the stock market to fall 50% and end up overvalued, as he says it is now. Still, he says, “I’m taking a big risk” making such a forecast.

Or is he? An extreme forecast doesn’t merely grab your attention; ironically, it may strike you as even more convincing than a moderate prediction. A classic psychological experiment at the University of Michigan showed that 54% of people preferred an extreme prediction about stock prices to a more-temperate one. They apparently believed that a forecaster must have high confidence and a solid rationale in order to justify making a dramatic prediction.

So, while Dow 1000 may or may not be a good forecast, it isn’t bad marketing for newsletters that cost $19 a month, as Mr. Prechter’s do. Extreme predictions tend to be popular at market turning points: Back in early 2000, a bullish book called “Dow 36,000” hit the best-seller lists—right before the bull market went into the abattoir. Nowadays, you can buy a used copy for one penny online, if you don’t mind paying $3.99 for shipping.

Like all technical analysis, this forecast looks at past prices, not future earnings. A 90% drop in the Dow (if the weighting of its 30 companies didn’t change) would leave only one of the components — IBM — trading above $10 a share. Alcoa, Bank of America, General Electric and Pfizer would be under $2 apiece, in danger of being delisted by the New York Stock Exchange.

To get to Dow 1000, the earnings of these leading companies would have to fall by a punishing amount — and investors would have to price them at record-low multiples of those ravaged earnings. Take Pfizer: One way it could lose 90%, says Jeffrey Yale Rubin, director of research at Birinyi Associates, is if its earnings shrank by 70% and its stock traded at a price/earnings ratio of 2.3.

For the whole index, one path to 1000 would be a 65.6% fall in earnings and a P/E of 5, Mr. Rubin says. Earnings fell further during the Great Depression, and the Dow’s P/E touched 5.3 in 1979, but never have the two measures gone so low in tandem.

Before their valuations could hit such absurdly low levels, public companies would go private. If Coca-Cola ever traded at five times its earnings, Warren Buffett would buy the whole company faster than you could spell “Vanilla Coke Zero.”

When I asked Mr. Prechter if such valuations were realistic, he replied that earnings and dividends must fall drastically to parallel previous bear-market lows. He added that deflation and “social unrest” will “change the perceived value of holding stocks.” In that case, a market crash would be the least of your worries.

In the financial markets, nothing is impossible. But in my view, Dow 1000 is about as close to impossible as you can get.

Source: The Wall Street Journal