The Dow Roller Coaster

Following the stock market's March 23 outburst, the Dow Jones industrial average is now 21% above its March 9 low. But to many prophets of doom, the Dow's resurgence is nothing more than a bear-market rally, a temporary advance that is destined to disappoint the bulls for the umpteenth time since last summer. In their terminally bleak view, not only will the current revival prove ephemeral, but the Dow is still likely to descend to levels that a year ago would have seemed unimaginable. In their view, the Dow at 5000 is likely, Dow 3500 is possible and even Dow 2000 can't be ruled out.

Although professionals focus on the broader Standard & Poor's 500-stock index, the Dow is the best-known barometer of the U.S. stock market's health. The Dow dominates media coverage and permeates the public consciousness. You may know where the Dow is within 100 points yet be clueless about the level of the S&P 500.

But the Dow has lost some relevancy in recent years, particularly since the financial stocks in the average began to implode more than a year ago. The Dow's components don't represent the 30 biggest, best or most important U.S. businesses anymore -- not by a long shot.

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In recent years, the Dow has had more than its share of companies in crisis. Among its current constituents are Citigroup, which is on federal life support, and General Motors, which is no longer among even the 500 biggest U.S. companies in terms of stock-market value. Two other Dow stocks -- Alcoa and Bank of America -- sell for less than $10 a share, and a third, General Electric, trades for just a tad more than a ten-spot. Until six months ago, the now bitterly maligned AIG was in the Dow.

Still, forecasting the Dow makes for great sport (even if so few can do it consistently well enough to make the effort worthwhile). So let's give the bears their due and examine four different scenarios for the Dow, along with the probabilities of their occurring.

Outcome 1: We've seen the bottom, 6440 (intraday) on March 9, with the Dow 55% off its October 2007 record.

Probability: About 60%

One way to assess the Dow is to consider the collective earnings of its members-in effect, treating the 30 stocks as one mega-security. Unlike the S&P 500, which is weighted by each stock's market capitalization, the Dow is a price-weighted benchmark. The higher a member's price, the more impact it has on the Dow's movements. (The Dow's free public Web site explains this and more about the average's mechanics and its background).

The highest-priced Dow stocks happen to represent the average's best-performing businesses, among them IBM, Johnson & Johnson and Wal-Mart. Those three account for 21% of the average. Add Chevron and Exxon Mobil, which stand to benefit from what looks like a new uptrend in oil prices, and you have 35% of the Dow.

By contrast, the Dow members with the most-uncertain futures -- Citigroup and Bank of America, which are pure financial stocks, and General Electric, which has a strong financial-services component -- trade, as mentioned earlier, at or near single-digit prices. Their disappearance would have little impact on the Dow (although, admittedly, their demise would probably lead to panic selling and could exacerbate already weak economic conditions).

At any rate, Dow Jones itself figures that the average should trade at about 13.6 times its members' combined earnings during 2009. But what might those earnings be? This is a complex calculation that requires you to add the estimates for the 30 companies and then apply the Dow's "divisor," a factor that accounts for stock splits, additions and deletions over the years. Skipping the details, let's assume 2009 earnings for the Dow of $80, which would be roughly the same as last year's figure, and adjust it by the divisor, which is 0.1255etc.... That gives you $637. Multiply that by 13.6 and you get the Dow at 8666, 11% higher than the March 23 level.

A bull could say that is eminently reasonable, but remember that analysts tend to be overly optimistic, so today's earnings estimates are probably too high. Plus, if inflation heats up sometime down the road, that 13.6 price-earnings ratio may be too high. So, to be conservative, let's assume a P/E multiple of 11 on the $637 figure. That gives you a Dow of 7007. That's lower than the latest close but well above the March 9 low.

Outcome 2: Dow 5200, or 64% below the record high.

Probability: 30%

Suppose you don't buy the idea that business conditions will improve in the second half of 2009. Suppose the economy continues to sink and corporate profits go from lousy to dreadful. If so, maybe the likes of Johnson & Johnson and Wal-Mart Stores can hang tough and keep their earnings steady, but the industrial heart of the Dow average -- Boeing, Caterpillar, DuPont, 3M, United Technologies -- could see further deterioration in their businesses. They will issue cautionary outlooks regularly, lay off more employees and perhaps cut their dividends.

Under this scenario, figure a $15 haircut on the Dow's earnings, to $65. With gloom pervasive, investors will trim back what they're willing to pay for those still-iffy earnings, so figure a P/E of 10. Divide $65 by the Dow divisor, multiply by 10 and you get Dow 5177. Ouch!

Outcome 3: Dow 3000, or 79% below the record high.

Probability: Less than 10%

Spooked by higher inflation, fast-rising interest rates and still-weak profits, investors knock down the Dow to book value. Book value, also known as net worth, is the gap between a company's assets and its liabilities on the balance sheet, divided by the number of outstanding shares. For the Dow to trade at book value would be truly ugly, tantamount to declaring the irrelevance of stocks.

It would essentially be saying that investors assign no value to corporate America's future profits and dividends. After all, it's the expectation of future profits and dividends that causes investors normally to value shares as a multiple of profits and of the net worth on the balance sheet. It is also why the shares of money-losing companies do not automatically trade at zero. But if the future offers shareholders nothing of value, why own the stock at any price? Why not just buy a company's bonds, which at least promise to pay out cash (in the form of interest) on a regular basis?

As of the March 23 close, the Dow industrials trade at 2.5 times the average's book value of 3115. From 2003 until the end of 2008, by contrast, the Dow 30's price-to-book-value ratio swung between 2.9 to 4.2. On a price-to-book basis, the Dow has already taken quite a beating.

But David Tice, the founder of what is now called the Federated Prudent Bear fund, thinks the economy is in such a mess that the Dow will eventually fall to roughly book value (see view From His Lair: Dow 3500). Tice specifically calls for the Dow to bottom at 3500, but why stop there? Under this wretched scenario, figure on the Dow hitting book value, which will probably drop a bit from its current level as Dow members report additional losses. But whether the Dow bottoms at 3000 or at 3500 is practically beside the point. In either case, it's a wipeout.

Outcome 4: Dow 1558, or 89% off the record high.

Probability: Near zero

Why so precise with this horrific scenario? The 89% plunge is precisely how much the Dow fell from 1929 through 1932, the period coinciding with the onset of the Great Depression. If the Dow drops to 1558, a level it last saw in January 1986, it would almost surely signal an economic cataclysm, followed by unfathomably high unemployment and mass homelessness.

But as gloomy as things appear now (maybe they're a little less gloomy after the Dow's nearly 500-point advance on March 23), the bet here is that steps taken by the U.S. and other nations will avert a depression and help bring an end to the recession, probably by the end of 2009. If so, the question isn't how low the Dow can go, but whether we're in a new bull market and how much the venerable benchmark can recover.