Call me a raging bull. Anyone who has followed my writing on RealMoney since December 2000 knows that I never predict specific levels in the market indices. Until now, that is. I won't give you an exact date, but I will say this: On the basis of my quantitative valuation work, I wouldn't be surprised if the Dow Jones Industrial Average trades in the 13,000-15,000 range over the next two to three years. Any observer of the market can recite a litany of reasons to be cautious on equities. Leading the list is our hyperactive Federal Reserve Board. Rather than letting the markets be markets -- fulfilling their function of flushing out inefficiencies and imbalances -- the Federal Reserve has adopted a strategy of micromanaging the economy. Only a couple of years ago, the Federal Reserve pushed interest rates to 45-year lows amid angst over the lack of growth and the potential for a deflationary spiral. Now the Fed is on an unprecedented hike-a-meeting pace in an effort to fight another phantom, inflation. Equity investors should be concerned. Look at 100 years of interest rate history and there is no exception to this rule: Flat-to-inverted yield curves always presage economic weakness, usually a recession. At the current pace of increase, the curve will invert (when short rates exceed long rates) in a couple of months. In addition to high interest rates and a potentially weaker economy in 2006, there is plenty more to worry about: high energy prices, falling consumer confidence and a costly and seemingly unending war in Iraq. But the key is, by my calculations, that these worries are already discounted in stock prices, and then some.
In addition, over the last six years, the businesses of 10 of the 30 Dow components have increased in value by between 50% and 100%: Altria ( MO) American Express ( AXP) Citigroup ( C) Coca-Cola ( KO) General Electric ( GE) Johnson & Johnson ( JNJ) McDonald's ( MCD) Pfizer ( PFE) Procter & Gamble ( PG) Walt Disney ( DIS). With two-thirds of the companies in the Dow profoundly undervalued, a call for the average to hit 13,000 to 15,000 in two to three years is not particularly bold. Most of the businesses in the Dow will be more valuable in two to three years. And the current stress in the economy, even an economic downturn in 2006, will be a distant memory.
Several Dow stocks can be purchased today at a hefty discount and, importantly, these assets will be worth even more over the next few years. I expect this basket of four Dow stocks will return 50%-75% to the investor over the next three to four years: Wal-Mart ( WMT): This one is easy, as the business value doubles like clockwork every six years. There is very little operational variance in this model and no serious competitor with the girth to challenge its procurement, purchasing and distribution advantage. Investors are making a mistake if they overlook the growth opportunities extant for this model. Even if I ratchet down growth expectations a bit, I still calculate a $75-$80 value in three to four years, or 67% above the current $45 quote. Microsoft ( MSFT): This stock traded as high as $60 a share in 1999 in the midst of the tech bubble, when the business was worth $18 a share. Since 1999 the business has grown in value to $29 a share. Using modest growth estimates, the value will grow to $40 or more a share in three to four years. That's 60% above the current quote of $25 a share. There's a chance that $40 a share may prove conservative, especially if the company uses its ample cash position and free cash flow to aggressively shrink the share base. Boeing ( BA): Investors have several levers working for them that will unlock value in Boeing stock over the next few years. Commercial aerospace demand will be robust for many years to come, particularly in Asia, where Boeing has a strong foothold. Airbus lacks the capital to develop a serious alternative to Boeing's 787, which is set to be rolled out in 2008. New CEO James McNerney took an already efficient profit machine in 3M ( MMM) and made it even more efficient. Boeing should produce big earnings gains over the next three to four years as McNerney works with Boeing's significant operating margin leverage. Expect at least $110 a share over the next three to four years, or about 70% higher than the current quote of $65 a share. Home Depot ( HD): This is another one of the elite companies in the current Dow with operating metrics that retailers of a generation ago, e.g., Woolworth, couldn't touch. Expect at least $62 a share in three to four years, or 55% above the current quote of $40 a share. In addition to the four mentioned above, other exceptional values in the current Dow Average include Intel ( INTC), American International Group ( AIG), General Electric ( GE), Citigroup ( C), and out-of-favor pharmaceutical companies Pfizer ( PFE) and Merck ( MRK). There are at least 11 more Dow stocks that are undervalued relative to their prospects for the next business cycle: Altria Group ( MO), Hewlett-Packard ( HPQ), American Express ( AXP), 3M ( MMM), Coca-Cola ( KO), McDonalds ( MCD), JP Morgan ( JPM), Disney ( DIS), Johnson & Johnson ( JNJ), IBM ( IBM) and Procter & Gamble ( PG).