Why the Dow Could hit 20,000 in 3 Years

In 1999, James Glassman and Kevin Hassett grabbed headlines with their book Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market. Their timing was impeccably bad. The Dow Jones Industrial Average peaked later that year at 11,900 and didn’t see the same levels again until 2006. The Dow eventually managed to surpass 14,000 in 2007, but hasn’t reached those heights since.

At the risk of following down this dubious path, this may be a good time to once again predict big things for the Dow. After all, corporate profits — a key driver of market performance — are far more robust than when Glassman and Hassett made that bold prediction more than 10 years ago. But forget about “Dow 36,000.” Instead, focus on the prospect of the Dow hitting 20,000 within three years. Here’s how it could happen…

A bull run?
To move up from the current 12,600 level to 20,000 by the summer of 2014, the Dow would need to rise about 16.5% each year — or about 58% in a three-year period. In the past 25 years, the Dow has risen by this much on at least 13 occasions. During those times, there was only one period of sustained annual gains, when the Dow rose an average of 26% from 1995 through 1999. The key question: what would it take to justify a three-year, steady, robust gain? It all comes down to corporate profits and the multiple investors are willing to assign to these profits.

#-ad_banner-#When that bold Dow 36,000 prediction was made in 1999, all of the companies in the S&P 500 earned a collective $51.68 a share. The S&P 500 finished the year at 1,469, implying a market multiple of 28.4. This compares with an average multiple of 13.5 from 1975 to 2010. In effect, those authors made their prediction when the market was already twice as expensive as the norm — and they were arguing for another 150% move in the Dow. (I should note this analysis uses Dow 20,000 as a milestone but S&P 500 profits as the litmus for market multiples, since S&P 500 profits are the widely-used measure.)

Right now, the S&P 500 trades for about 13 times projected 2011 profits of $103 a share. This is a reasonable number in light of very strong corporate profit margins in a time of real economic concerns. One could even argue the current multiple could expand to above the norm if the economic concerns receded and the economy started to grow at a steady 3.5% clip.

To be sure, corporate profit margins have peaked. But if history is any guide, then 3.5% gross domestic product (GDP) growth would translate into 7% to 10% annual sales growth for many companies, accompanied by 15% profit growth. These are admittedly rough estimates and round numbers, but it would be in the ballpark. If profits indeed grew 15% annually, then the S&P 500’s aggregated earnings would reach $157 a share by the 2014.

Let’s also assume inflation remains largely in check and the Federal Reserve hikes rates by only 200 to 300 basis points from current levels. In this environment, investors might be willing to assign a slightly more robust multiple to the market, perhaps 15 times aggregated earnings. Apply this to the projected $157 a share, and the S&P 500 would rise to 2,500 — a roughly 75% gain during the next three years. Note that when we looked at the prospect of the Dow hitting 20,000 before, we were talking about a 58% total gain. So Dow 20,000 is surely within reach by 2014 if the chips land the right way.

What could go wrong?
For starters, companies — especially those selling to consumers — would be hard-pressed to grow at a solid clip even if unemployment remained at stubbornly high levels. The key swing factor in the economy involves hiring trends that would steadily reduce unemployment below 7%. This was the case in the middle of the 1990s. As companies finally expanded payrolls, consumer spending soared and the Dow posted a robust five-year run, as mentioned above.

As a second concern, it may prove tricky to get inflation just right. In an ideal world, the economy grows at a moderate enough pace in order to avoid bottleneck and pricing pressures. In a worst-case scenario, the Fed‘s extended balance sheet and the government’s ongoing borrowing needs could eventually lead to a spike in rates that would help find buyers for our debt. If inflation sharply moved up and the Fed needed to hike rates well past 5%, then there’d be no way investors could afford a slightly rich multiple for stocks. In such a scenario, “Dow 10,000” would be the buzzword.

Action to Take –> The second half of 2011 is going to determine where we are likely to be in 2014. This is because the economy is showing both signs of life (as evidenced by recent robust data in capital goods spending) and signs of weakness (as seen by weekly jobless claims that can’t seem to fall below the all-important 400,000 level). One of these forces will eventually win out. If the economy is indeed creating jobs at a decent clip later this year (consistently above 200,000 a month), then it may end up on a self-sustaining growth path — and the Dow would be on its way to 20,000.