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We are big bears - to the point where some people consider us a top candidate for the camp of Robert Prechter of the Elliot Wave, who believes that the Dow will return to 1980 levels of about 1000.

We do have one major quarrel with Prechter. He only uses price charts. We like to develop theories of causation to support the patterns contained in his charts (which do capture a great deal of market action and psychology).

Prechter believes (as we do) that the US stock market has been in a bubble since 1980, and that it will therefore return to earlier levels of 1000. We don't take this literally. But we agree with Prechter's unstated premise, that the Dow will return to 1980 levels after adjusting for intervening inflation. With this major caveat, we're talking about a Dow of not 1000, but of more like 3500.

That's because we believe that the "blue chip" US market, as personsified by the Dow, is a "sine wave," not a growth vehicle, and that what passes for growth in the US stock market is mostly inflation. So does Bill Gross of Pimco, who calculated that the "real" investment return, or 90%+ of it, came from dividends in the twentieth century. Taking out inflation, capital gains would be 0.6% real a year.

Some thirty years have passed since 1980. If you compound the Dow for those years at 0.6% real a year, the cumulative gain would be just over 20%. Starting from a base of 1000, the Dow might be 1200 real. If you take the trough as more like 800, then a "real" Dow of 1000 is a genuine possibility today, which means a Dow with a "3" handle at its next trough.

That's because in the past century, the Dow's value can range from one half of our proprietary "investment value" metric (now about 7000), to about three times that, or over 20,000. Yes, Jeff Miller, a 20,000 Dow is within the realm of possibility. But so is a 3500 Dow (half of 7000), which is our "revised Prechter" metric. Consider those the ceiling and the floor. The last two bottoms came in 1932 and 1974, a little over 40 years apart. In 2010, we are not far from the "40" year mark, although it might not be this year.

The problem with Prechter's price charts is that they don't encompass economic variables like inflation, so they don't provide any support for stock prices at one level or another. Contrary to what the academics teach, stock prices don't follow a "random walk." Instead, they go places, based on information (and sometimes misinformation) available in the marketplace. So, I don't want to hear about price levels, except in the context of other, causal, variables. Here are some:

Suppose the S&P 500 earnings ($56 a share in 2009) "flat-lined" for about five years. And suppose that the P/E ratio went to bear market lows of 5 times earnings as a result. That would imply a 300 S&P 500, and a 3500 Dow, which is certainly within the realm of possibility. More to the point, that is our BASE CASE in the quasi-depressionary environment we foresee for that time.

Hence, our "modified Prechter" theory is that the Dow will return to 1980 levels -- adjusted for inflation. This would put the index in the low to mid-3000s, unless you have raging deflation that takes us back to 1980s price levels as well, which would support Prechter's hypothesis. But he didn't specify the appropriate conditions when he made his prediction, which is why it is not as useful as it ought to be.

Disclosure: No positions

Source: Why Prechter Is Probably Wrong About a 1000 Dow