University of Pennsylvania's Wharton finance professor, Jeremy Siegel, predicted earlier this year that the Dow Jones Industrial Average will likely hit 15,000 or even go as high as 17,000 by the end of 2013. He gave a 75% chance for the Dow to hit 15,000 and a 50% chance of it hitting 17,000.
Click to enlarge image.
Siegel cited the historically low P/E ratio of 13 on the Dow's 30 stocks as the main reason for the potential sizable rise in the average. The long-term average P/E ratio for the Dow is about 15. He pointed out that the market had such a bad performance in the 2000s because the P/E ratio started the decade at 30, twice the average. Now that the Dow's P/E ratio is below average, the Dow has room to run higher. Siegel said that the market never had bad stock returns in the three- to 10-year period following a P/E ratio starting point of 13.
Interestingly, the Dow is currently more undervalued than the S&P 500. The S&P 500 has a P/E ratio of 14 as compared to the Dow's 13. So, it looks like buying a Dow fund has the potential to be a better investment compared to S&P 500-related fund.
There are a few ways to play Jeremy Siegel's prediction. Investors can buy the SPDR Dow Jones Industrial Average (DIA) and collect a 2.4% dividend yield while the price rises. This is the simplest way to play it. Investors can also consider buying a January 2014 LEAP option. If we go with the more conservative 15,000 target, this represents an 11% rise in the Dow. We can capture this rise by buying the January 2014 $145 call option for about $395. We only need about a 7% rise in the Dow for the option to be in the money by the expiration date.
The reason for considering the LEAP option is to achieve a higher percentage gain. If the Dow hits 15,000 and an investor buys DIA, the gain will be about 11%. However, if the LEAP option was purchased the investor could have a gain of over 80%. The risk with the LEAP option is that if the Dow doesn't gain at least 7%, then he or she would lose the entire cost of the option ($395). Therefore, those who choose to buy the LEAP option should only use money they can afford to lose.
Let's say the Dow does hit 17,000. The investor who simply purchased shares of DIA would gain about 26% plus dividend payments. The investor who purchased the January 2014 $145 call would have gained about 280%. So, you can see the significant difference in risk/reward.
I would recommend most investors purchase DIA shares and collect dividends. This is the simplest way to play Siegel's prediction, and if he's wrong, you can still hold on to the shares for the long term.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.