Target Prices Highlight Risks

8/31/2009


Under the Dow Theory, the price movements of the Dow Industrials and Dow Transports reflect all the hopes, disappointments, and knowledge of investors. Because the averages discount everything, their price trends show whether investors expect things to improve or worsen.

Still, nothing says the Dow Theory must be used to the exclusion of all other considerations, and one advantage of using the Industrials and Transports is the limited number of stocks in these averages. We projected target prices for all 30 Industrials and 20 Transports, assuming that all 50 companies meet consensus profit estimates for next year — and that all 50 stocks trade at their average trailing price/earnings ratio of the past 60 months. For four Transports expected to lose money next year or lacking meaningful historical P/E ratios, we assumed share prices would climb 10%.

Based on these assumptions, the Dow Industrials would trade at 11,626 in early 2011, up about 22%, while the Dow
Transports would trade at 3,733, up less than 1%. Other notable points:

Consensus profit estimates for next year project big gains for the financial, cyclical, and energy components among the Industrials. The 30 Industrials are expected to deliver 24% average growth in per-share profits, but one-half of the companies are expected to report growth of less than 10%.

A return to 60-month average trailing P/E ratios would put valuations above long-term norms. Excluding modestly valued Chevron ($71; CVX) and Exxon Mobil ($71; XOM), the average 60-month P/E for the remaining 28 Industrials is 17.

Much of the upside implied for the Dow Industrials reflects forecasts of big gains for blue chips trading at large discounts to 60-month average P/E ratios.

The Transports seem vulnerable to economic disappointment. Railcar loadings and truck traffic remain weak. Yet per-share earnings for the 20 Transports are expected to total more than $35 next year, up from $14 in the current year.

Conclusion

Will economically sensitive companies deliver the huge profit gains forecast for next year? Will P/E ratios return to levels above long-term norms?

While we’re skeptical on both counts, we could be persuaded. We’d like to see today’s bullish consensus tested by meaningful corrections in the Industrials and Transports, followed by rebounds to new highs as investors discount an improving profit picture. In the meantime, we’re holding about 30% of equity portfolios in a short-term bond fund — and emphasizing modestly valued shares of reliable growers with the other 70%.


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