Saturday, March 28, 2009

DOW will retest the Bottom.

There is an interesting article about the DOW's Future. And I would go with the first scenario:


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.

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