Just Ahead: Dow 40,000?

Editor's Note: Jon D. Markman writes a weekly column for CNBC on MSN Money that is republished here on TheStreet.com . He's also a regular contributor to RealMoney , TheStreet.com's subscription site. If you'd like to see all of Jon Markman's RealMoney commentary, click here for information about a free trial.


The professional Wall Street spin machine has kicked into overdrive in the past two weeks. A slew of strategists have stridden into the teeth of Hurricane October with forecasts saying stocks in the final three months of this year will clock in with a juicy 8% gain -- equal to the average fourth-quarter gain over the past decade.

As you might expect, there is plenty of bearish dissent, and the doomsayers certainly appear to have the upper hand of late. But more remarkable, perhaps, is a growing minority of forecasters who are looking for much, much better results.

Louis Navellier, the fund manager and newsletter publisher, is typical of the mega-bulls, advising private clients over the past weekend that their "best buying opportunity in six months" was last Friday. "If you have any cash, invest it right now," he wrote. "The next few weeks will be phenomenal."

More objectively, the quantitative team at Thomson Financial put out a note on Monday stating that their Market Model Risk Premium -- which gauges the extent to which investors are so worried about the future that they are overpaying for the safety of government bonds -- has risen to a record level that tied a mark set in September 2002. That was, as the Thomson research team pointed out, an "excellent buying opportunity."

The Dow at 40,000?

Yet even these sound like doomsday scenarios compared with a cadre of analysts who argue that stocks are actually on the verge of a historic breakout. They say their calculations suggest the Dow Jones Industrial Average, now at 10,200, will rocket to 20,000 to 40,000 over the next three to five years, driven by improving global income levels, a boost in the money supply and the deployment of vast quantities of hoarded cash by companies and individuals.

As the market heaves and groans with dyspepsia this week, it's hard to imagine the super-bulls could be right. But maybe we should be open-minded for a moment and note that one expert's guess may be as good as another these days. While it's always tempting to side with the downers who moan about the negative effects of another Fortune 500 bankruptcy, higher interest rates, energy prices and inflation, we might just as well consider what might happen if the rebuilding of New Orleans, Biloxi and Islamabad let the good times roll again.

The two leading trumpet-blowers in the optimist brigade are Don Hays, a veteran Wall Street strategist who runs Hays Advisory, and Harry Dent, an economist-author who runs the HS Dent Forecast. Both believe the past 20 months of flat returns in the broad market indices have just about done their job of lulling investors to sleep in advance of a gigantic rush to much, much higher ground.

In late September, Hays told clients to expect gains of 100%-plus in the next couple of years, in part due to vast piles of individual and corporate cash being put to work amid "the reinvigoration" of the U.S. dollar and productivity. "The monetary liquidity floating around the world is so humongous, it is impossible to describe all the pockets overflowing and looking for a home," he said, adding that he believes U.S. GDP is on track to double to a 7% annualized rate, while inflation will remain in a 1%-to-2% range over the next decade.

Not to be outdone, Dent told clients on Oct. 1 that he "couldn't be more bullish for the next year and the next five years." He added: "Ignore the news and be investing as fully as your risk tolerance warrants. ... We are very close to the last great buy opportunity ahead of the greatest five-year stock bubble in history. And still, no one suspects such a bullish scenario while our long-term indicators say it is almost inevitable."

A Pattern Emerges, Again

A key element of both the Dent and Hays outlook is the observation that most extreme bull phases of the last century -- 1915 to 1919, 1925 to 1929, 1935 to 1937, 1985 to 1987 and 1995 to 1999 -- were preceded by major corrections (or crashes), followed by a strong initial recovery and then a one-to-two-year trading range.

Of course, the implication is that the crash in this case was the 2000-02 bear market and that the recovery rally happened in 2003 and the trading range was seen from 2004 to 2005. Dent suggests that the markets "are simply waiting for signs that the Fed can't tighten much further" and for oil to correct below $58-to-$62 support levels "to suggest a top in that bubble."

Naturally, most investors would love to see a renewed bull market, as it would run counter to the dour view that a cyclical bear is just around the bend. But the forecast gets a little more interesting when you begin to apply it to individual stocks. For in order for the Dow Industrials to double, either virtually all of those 30 stocks would have to double their earnings, or investors would need to decide that their price/earnings multiples should be twice as high as they are now.

Strangely enough, several of the Dow stocks won't get to their all-time highs even if they double.

Pharmaceutical giant Merck ( MRK), for instance, could shoot 100% higher and only get halfway back to its glory days. Chip goliath Intel ( INTC) could triple and still not get back to its 2000 high. And you can go down the line with the list to find similar examples, including Verizon ( VZ), SBC Communications ( SBC) and Walt Disney ( DIS).

Riding the Next Bull

Indeed, considering the walking wounded in the Dow, it's impressive that the index is only trading about 12% down from its all-time peak of 11,698, set in late 1999. You can certainly see that if oil prices moderated and investor mood began to lift, the venerable measure of the market could certainly approach and exceed its old highs while its sleepier components were just barely getting off the floor.

After that, it wouldn't exactly take much imagination to see a 50% move up to 15,000, as it would only require an advance in a stock like Intel, for instance, to $34.50 from its current perch around $23. It was there as recently as November 2003. Merck would only have to get to $38.77, where it traded only a year ago.

If the optimists' vision were to come into play, it would take a lot of investors off guard. Possibly the best way to guard against the chance that the Dow might take off without you would be to devote 5% to 10% of your funds, let's say, to a portfolio containing Dow industrials, transports and utilities that are considered the most favorable today under our StockScouter system. That way, you're probably going to be in great shape for a bull run, and you're unlikely to get badly hurt -- at least on a relative basis -- if bears gain firm control instead.

The last time I put together a similar list was Feb. 4, in a column titled " A Better Index: The Diversified Dow 18." That group of stocks is up 4.6% since then, vs. a 4% decline in the Dow Jones Industrials. My picks were led by a 39% gain in TXU ( TXU), a 12.5% gain in Norfolk Southern ( NSC) and a 7% gain in Altria Group ( MO).

Here are StockScouter's top choices now among the Dow Jones Industrials, Utilities and Transportation indices to consider, just in case the optimists -- against all odds -- are right this time. As you look down the last column, keep in mind that it takes a 100% move to get back a decline of 50%.

The StockScouter Dow 15
Name DJ Index SS rating 10/10 Close YTD Chg. % Chg. 5y high
Home Depot DJ Industrials 8 $38.02 -11.6 -46%
Coca-Cola DJ Industrials 8 41.98 1.3 -37
Wal-Mart Stores DJ Industrials 8 44.54 -16.6 -35
Exxon Mobil DJ Industrials 9 58.50 16.3 -11
United Technologies DJ Industrials 8 50.00 -3 -8
Caterpillar DJ Industrials 8 55.57 16.1 -7
GATX DJ Transports 9 37.74 27.8 -25
FedEx DJ Transports 9 88.04 -11.3 -14
CSX DJ Transports 9 44.39 12.5 -7
Burlington Northern Santa Fe DJ Transports 9 58.51 24.5 -3
CNF DJ Transports 8 51.82 2.8 -3
CenterPoint Energy DJ Utilities 8 13.65 22.9 -73
TXU DJ Utilities 9 104.23 63.6 -11
Dominion Resources DJ Utilities 8 78.85 18.8 -9
FirstEnergy DJ Utilities 9 49.82 28.5 -7
Source: MSN Money

Jon Markman, writer of TheStreet.com Value Investor, is the senior investment strategist and portfolio manager at Greenbook Investment Management, a division of Greenbook Financial Services. Separately, he is publisher of StockTactics Advisor, an independent weekly investment research service. While Markman cannot provide personalized investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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