Next Stop...Dow 5000?

I’d love to tell you that, having breached Dow 7000 Monday, 5000 seems out of the question, and that we should all make a brave stand here and go all-in on stocks. Sadly, the numbers suggest it’s at least possible that the Dow could shed another 2,000 points in addition to the more than 7,000 it has lost since October 2007.

Here are two reasonable ways to look at it, plus a third, not-quite-reasonable one:

If we price the market according to its dividends — indeed, investors did just that through all but the past two decades of the four-century history of stocks -- we’ve much further to fall. Stocks carried an average dividend yield of 4.9% over 200 years ended 2002. Let’s assume the $24 dividend forecast underlying the S&P 500 holds this year. (It might not, since a handful of companies have cut payments since Standard & Poor’s issued the forecast in early February.) That gives the index a yield of 3.4%. To revert to the historic 4.9% yield for stocks, the S&P 500 would have to fall to 490 — a 30% decline. A 30% decline on the Dow from Monday's price puts it just over 4700.

For more than 130 years stocks have traded at an average trailing price/earnings ratio of 15. The S&P 500 index stands at about 13 times trailing earnings now — a good sign, but maybe not good enough. We spent the past two decades at an average of 22 times trailing earnings, or 47% more expensive than average. If you believe stocks can now become too cheap by the same margin by which they were previously too expensive, expect eight times earnings on the S&P 500, or 434. That’s 38% lower. On the Dow, it’s below 4200.

If you wish to dispense with underlying fundamentals altogether and just compare our stock decline in percentage terms with the worst ones seen in similar economies, the news is even grimmer. Japan, the world’s next largest economy after the U.S., has been infected with a popped real estate bubble, wobbly banks, weak consumer spending and mounting government debt since the early 1990s. Its stock benchmark, the Nikkei 225, is 81% below the 39000 it topped in December 1989. A similar 81% drop from Dow 14000 would leave us below 2800, less than half today’s level. And finally, the ugliest comparison we can make is with America’s own stock market in the summer of 1932. The Dow hit 41—after topping 381 in 1929. That’s a decline of 89%. It’s the equivalent of today’s Dow losing another three-quarters of its value to close below 1600.

Don’t panic. Those last two comparisons are meant to demonstrate what people have survived in the past, not where we’re headed. As I noted in the December issue of SmartMoney Magazine, there used to be sheep in Manhattan’s Central Park. They were evicted in the 1930s, not because they had become troublesome tenants, but because when a quarter of workers couldn’t find jobs and the nation’s hungry homeless had started building shacks in public spaces, including the park, the sheep were feared too tempting a meal. Those were different times.

As I advised readers just over a week ago, don’t count on seeing Dow 5000, but invest as though it’s possible. That means holding a generous pot of cash. Financial planners say you need enough to live off for six months to a year, but I wouldn’t feel safe with less than two years’ worth, given the grim jobs outlook. Being ready for Dow 5000 doesn’t mean forsaking stocks altogether, since guessing the bottom is just that — guessing — and since the stock market tends to rise sharply long before recessions end. But it does mean favoring stocks with generous, safe dividends, so that you can reinvest payments and buy more shares as prices fall, even if you can’t add money to your portfolio.

For ideas on which stocks to favor, have a look here and here.