Home

    You are here

Will the Dow Fall to Below 5,000?

You are here

Dow Jones

Will the Dow Fall to Below 5,000?

Aug 24 2015, 06.47am GMT

STOCK.com

The question continually lurking in the background is whether analysts who are predicting a long term market decline are pessimistic doomsday fanatics, or knowledgeable commentators basing their predictions on fact?

This question regarding if the Dow Jones Industrial Average (DJIA) is likely to decline to below the 5,000 level is addressed by columnist, Brett Arends, and he expresses the view that after the DJIA fell by more than 3% to close at 16,460 on Friday, a predictable short term rally is on the cards. This does not indicate a resurgent bull market, but is rather the normal market reaction to a steep drop in prices which could well drop further after a brief respite. The reality is that investors should realize that this could develop into what the author calls a ‘perma-bear market’ which could take the Dow all the way to 5,000.

Arends says, “For 30 years, stock prices have been increasingly boosted by financial factors: collapsing interest rates and Federal Reserve manipulation, culminating most recently in ‘quantitative easing’.”

He cautions that while he is not predicting a collapse of the Dow all the way down to 5,000, in contrast to the bulls who believe up is the only way the market can go, the more likely scenario is a fall to between 10,000 and 12,000.

A study of stock market history shows that Wall Street tends to move in long swings upward followed by long swings downward, with a swing in either direction lasting for long periods, up to 20 years in some cases. Arends suggests that an upward move, which started in 1982, was one of these long swings and that the downward cycle, which first started in 2000, has not yet ended.

As stock market historian Russell Napier underlines in his book “Anatomy of the Bear”, during the last 100 years, there are distinct periods, 1921, 1932, 1949, 1974 and 1982, in which the downtrends have not ended until share valuations dropped to around 30% of the replacement value of company assets. Napier applies an economic metric known as Tobin’s Q ratio.

A definition of Tobin’s Q ratio, is the ratio of the market value of a company’s assets (measured by the market value of its outstanding stock and debt) divided by the replacement cost of the company’s assets (book value).

A Q of between 0 and 1 implies that the cost to replace the company’s assets is greater than the value of its stock, meaning the stock is undervalued. Conversely, a Q of higher than 1 means that the replacement cost is less than the value of the stock, or that the stock is overvalued. The 0 - 1 reading means the equivalent of a percentage greater than 100%, while anything above 1, drops the percentage to less than 100% or the number at which the market and asset values are the same.

Professor Stephen Wright of London University and Andrew Smithers of Smithers & Co., a London based financial consultancy, have tracked the validity of the Q ratio theory over the past hundred years. Their finding is that there has been no better long term investment guide than this ratio. They claim it has had greater accuracy than the cyclically adjusted price to earnings measure, the “Shiller PE” which is also suggesting that U.S. stocks could be facing a long term downtrend.

Looking at the accompanying chart for the period 1949 to 1994, the period before the boom and subsequent bull market of the late nineties, the historic Q reading for stocks was 57% and a fall to that level would result in the Dow at around the 9,500 level. A fall to historic bear market lows with a Q of 30% would mean a Dow of 5,000.

Dow Jones

Indices Block Actions

Trading Platforms

MetaTrader

Through a simple native App download, be ready to log on to the powerful, intuitive MT4 platform and trade multiple assets on your desktop or through mobile

More on MetaTrader

WebTrader

Online access - anytime, anywhere - to your secure STOCK.com account, through desktop, tablet and mobile interfaces with no download necessary

More on WebTrader

Trading in CFDs involves significant risk to your invested capital