Dow 4,000 ?

There are few steadfast investing principles. Dynamic markets constantly change and investors must be willing to adapt their strategies. However, one rule we should always follow is to trade with the primary trend. Trying to trade against the underlying current of the market will surely result in losses. Those doing so think of themselves as contrarians. In reality, they are foolish.
For months in my weekly newsletter EPIC Insights, I have repeatedly stated that the primary trend is bearish. When stock markets worldwide hit synchronized lows in November 2008, we were given notice. During the subsequent rally, markets began diverging and raised hopes that the primary trend was changing. This week that hope was crushed. As the chart shows, last week markets pushed to synchronized 2009 lows, on many occasions violated their 2008 lows, and have reinforced the primary trend as bearish:
Index Prior Low Date of Low Recent Low Date of Low New Low?
Dow Jones Industrial 7,552 11/20/2008 7,366 2/20/2009 Yes
Dow Jones Transport 2,989 11/20/2008 2,699 2/20/2009 Yes
NASDAQ 1,316 11/20/2008 1,440 1/20/2009 No
S&P 500 752 11/20/2008 770 2/20/2009 No
Wilshire 5000 7,451 11/20/2008 7,750 2/20/2009 No

FTSE 100 3,781 11/21/2008 3,889 2/20/2009 No
DAX Index 4,127 11/21/2008 4,015 2/20/2009 Yes
CAC 40 2,881 11/21/2008 2,751 2/20/2009 Yes
NIKKEI 225 7,163 10/27/2008 7,416 2/20/2009 No


With a primary bear market, we are unable to predict either the duration or severity of price declines. Instead, we turn to past experiences to guide us. Unfortunately, nothing in the past indicates promise for the immediate future.
For the economy, the current downtrend has already reached levels of prior deep recessions. However, as the storm clouds continue gathering we should expect this downturn to be more severe than any since the Great Depression. With indecisive policymakers who have used all traditional stimulative actions (i.e., interest rate reductions from the Federal Reserve and increased spending from the Federal government), we face an uncertain world with few concrete answers. Having used debt to finance our lifestyles for nearly 60 years, Americans are being forced to reduce debt and curtail spending. This combination should result in more economic malaise over the coming months.
Looking at stock market performance over prior bear markets, as shown in the following table, the picture this time around is equally bleak.
Bear Market Date of Market Date of Value
Market Peak Peak Bottom Bottom Lost Duration
1929 Crash 381 9/3/1929 41 7/8/1932 -89% 714 days
1968-1970 985 12/3/1968 631 5/26/1970 -36% 368 days
1973 -1974 1,052 1/11/1973 578 12/6/1974 -45% 482 days
2001-2002 11,338 5/21/2001 7,286 10/9/2002 -36% 347 days
NASDAQ 5,049 3/10/2000 1,114 10/9/2002 -78% 648 days
Current 14,165 10/9/2007 7,366 2/20/2009 -48% 344 days

While the current bear market has erased 48%, in line with the declines seen in most bear markets, the duration of 344 days is the shortest on record. If you follow the belief that this bear market is unwinding 60 years of excess spending, we should expect the Dow to lose at least 70% from peak to trough and the bear market to last in excess of 600 days. Combining these data points, the market may not bottom until the Dow approaches 4,000 sometime in the next 9 to 12 months.
Finally, most major bear markets do not end until prices have reached bargain levels. This often equaled a P/E multiple near 6-7 and a dividend yield in the same area. Currently the Dow sports an estimated P/E of 11 and a dividend yield of 4.3%. In order to achieve bargain levels, the Dow would need to trade near 4,000.
The picture painted here is very ugly. Most investors have a great deal of difficulty accepting the belief that the Dow could trade to such levels. I hope I am being overly cautious, but fear my analysis will prove correct. With such a drastic selloff predicted, earning meaningful returns will be difficult. Becoming excessively short stocks will provide the opportunity to be forced from your position by unexpected bear market rallies, while going long stocks that seem cheap will lead to losses and frustration as those cheap stocks become cheaper. Instead, I will stick to my core competencies as a value investor and search for cheap stocks that offer limited risk and outstanding return potential. However, I will not buy these shares blindly but will look to use index exposure to hedge all my risks.
Continuing a theme used in last week’s fundamental trade, I advise readers to become more short of the broad market. Last week, we shorted SPDR Trust (SPY) and iShares MSCI EAFE Index Fund (EFA) with excellent results. This week’s trade entails using options on SPY as a means to profit. Using a September 2009 expiration, I recommend shorting the SPY 77 calls (ROQ+IY) and using the proceeds to buy the SPY 77 puts (ROQ+UY) as this week’s fundamental trade. Cover 5% of your portfolio with this trade (six contracts for my portfolio).
By EpicAdv