Prechter's 'Dow 1000' Prediction: Nonsensical

Includes: SH, SPY
by: Logical Thought

Although I'm quite bearish about the next three to five years, even I think that Prechter's Dow 1000 forecast is nonsensical.

The "nightmare scenario" (which I DON'T think will happen) would be if we returned to the worst four consecutive operating earnings quarters of the current recession (Q4 2008 through Q3 2009), in which case the S&P 500 would earn around $40. If we then put an 8x multiple on that (there's no way it's going to 5x in a ZIRP environment, and if we had enough inflation to eliminate ZIRP we'd also have much higher nominal earnings than $40), we'd have the S&P 500 at 320, which would be around 30% of its current value, and would correspond to around 3100 on the Dow.

A more realistic downside scenario would be to annualize the just-under $14 operating earnings from Q2 of 2009, which was when a lot of the cost-savings "benefit" of having fired a lot of people was built in (don't forget, we're talking "operating" rather than GAAP earnings here) and yet most government stimulus (which is now going away again) WASN'T. This would provide around $55 in S&P operating earnings, and an 8x multiple on that would be 440, which would correspond to roughly Dow 4200.

I'd say there's around a 10% chance of this happening, and that's about as bad as it could get. I would, though, say there's around a 30% chance of achieving those $55 in SPX earnings and having a 10x multiple slapped on them, and this would correspond to SPX 550, which would be around Dow 5200. Anyone who thinks THAT'S impossible (or even "extremely unlikely") would have to be betting on one of the following things:

  1. A near-term inflation burst (in what clearly seems to be a near-term deflationary era) will raise nominal prices to artificially higher levels, or
  2. The higher taxes and reduced state & local government spending that we're going to have going forward vs. what we had in Q2 of 2009 (when, again, there was around $14 in SPX operating earnings) will be MORE THAN offset by inherent economic growth in the upcoming absence of government stimulus. (If the growth is only enough to exactly offset the upcoming higher taxes and state & local spending reductions then SPX quarterly earnings would theoretically remain at $14), or
  3. The kind of earnings shrinkage we're talking about here (to $55) gets a higher multiple than 10x (even though major bear market multiples historically trough at a single-digit number).

Thus, my suggestion is that one be prepared for the very realistic possibility (albeit, not "probability") of Dow 5200/SPX 550, and therefore hold enough cash in reserve so as not to be "all-in long" at levels significantly higher than that.

Disclosure: Author is short SPY and long SH