By Tom Au

Robert Prechter spooked the markets recently when he called for a 1000 Dow using his Elliott Wave Theory. That would be a 90% drop from current levels that would signal a global economic seizure, making the Great Depression seem like a garden party by comparison. Things couldn’t get that bad, or could they?

We are big bears, to the point where some people would put us in the same camp as Prechter. But we do have one quarrel with him. He uses only price charts, which do not contain causal relationships (although they are sometimes useful in capturing short-term economic and social moods and trends). In that sense, he is flying “blind” (without instruments”).

Prechter has a point that would be seconded by other bears like Jeremy Grantham. There has been a stock market bubble since about 1980. And such bubbles basically return to where they start. Therefore, the Dow will go back to the levels at which it traded in 1980. Which, presumably, was 1000.

Except for one thing. A 1000 Dow today would be a far different animal from a 1000 Dow in 1980, because of inflation. Suppose we escalated that 1000 for the intervening inflation. That would give us a Dow in the mid 3000s, call it 3500. Now we have a workable hypothesis: the Dow will go back to 1980s levels (of 1000) adjusted for the intervening inflation.

We have our own model. Our proprietary “investment value” metric for the Dow (book value plus ten times dividends) is about 7000, meaning that it is somewhat overvalued where it is. More to the point, in the past eight years, there were two bear market lows on the Dow in 1932 (41 versus an investment value of 82), and in 1974 (584 versus 1118), of roughly half of investment value. These two observations are just over 40 years apart, suggesting that a similar low could be reached in 201?, that is, in this decade.

Where we disagree with Prechter is in our belief that stock prices are driven by market information (or misinformation). They don’t necessarily follow a random walk, like the academics hypothesize. So price levels aren’t really useful except in the context of related, causal variables. But the ones that do exist may be enough to support our “modified Prechter” theory. Besides the inflation adjustments used above, here are some more:

Suppose the S&P earnings ($56 a share in 2009) “flatlined” around $60 a share for the next five years. And suppose as a result, the P/E ratio went to bear market lows of about 7. This would imply an S&P level, of just over 400, and perhaps 3500 on the Dow. This is, in fact, our base case.

Our hypothesis is supported by an observation made shortly after the turn of the century by Bill Gross, the bond guru at Pimco. The average annual investment return on blue chip U.S. stocks (as represented by those on the Dow) during the twentieth century, was inflation, plus dividends, plus 0.6% a year real. For all its “sound and fury,” the inflation-adjusted price action on the Dow is much like a sine wave that ebbs and flows around a line of 0 (or if you prefer, 0.6%).

Although thirty years have passed since 1980, the 0.6% gains would have taken the Dow from 1000 to a little over 1200 in real terms over that span. Or if you consider the fact that the Dow was below 800 as late as 1982, a real 1000 Dow is a genuine possibility.

We don’t take Prechter literally (unless he’s hypothesizing a deflation that will take us back to 1980s price levels). We do, however, believe his main premise, that the Dow will revisit earlier (1932 and 1974) lows in real terms. The problem with his charts is that ignore these fine points of causality. As such, they are better suited to analyzing short-term movements where inflation, and similarly time-dependent forces, are not a factor. Which is why his forecasts are less useful than they might otherwise be. We have done our best to restore their relevance.

Tom Au has over twenty years of experience in securities analysis and portfolio management for both equity and fixed income securities. He has worked for Value Line, Cigna Investment Management, and other organizations. Prior to joining R.W. Wentworth, he was an analyst of the "monoline" municipal bond insurance companies. He is the author of A Modern Approach to Graham and Dodd Investing (Wiley, 2004).