Barron's calls the bottom

One of these days, one of these guys will correctly call the bottom. It's Andrew Bary's turn in the Barron's cover story.

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The brutal bear market of the past year has affected all industry groups and nearly every stock. All 30 members of the Dow Jones industrials are in the red for the past 12 months and just one stock, IBM (IBM), is in the black for 2009. Within the S&P 500, just eight stocks are higher in the past year, led by Family Dollar Stores (FDO), which has gained 56%. The worst performer in the S&P 500: AIG (AIG), which is off 99%, to just 35 cents.

Sure, stocks could slide much further -- but they probably won't. By most measures, they are downright cheap.

AFTER THE STUNNING DECLINE OF THE PAST FIVE months that has left the Dow Jones Industrial Average and Standard & Poor's 500 Index more than 50% below their 2007 highs, a lot of investors are worried stocks could fall much further.

In a worst-case scenario, based on current earnings estimates and the most pessimistic reading of market history, the Dow could fall a further 25%, to 5000, and the S&P could drop to about 500. The Dow industrials closed at 6,627 Friday, and the S&P 500 ended at 683, both down 24% so far this year and both at 12-year lows.

The lousy economy is the main factor, but stocks haven't been helped by Obama administration proposals that would hurt a range of companies, including drug makers, managed-care firms and student-loan providers. Investors also haven't liked the president's plan to raise taxes on the wealthy. It doesn't help that the Street is calling this an "Obama bear market" and that some investors are looking to "Obama-proof" their portfolios, avoiding sectors targeted by the president.

However you feel about President Obama, he got at least one thing right last week: He said stocks are cheap for long-term investors. Our research shows that to be true, whether you look at stocks relative to book value, U.S. economic output, gold or a normal level of corporate earnings.

These factors, plus the huge amounts of cash now sitting on the sidelines, suggest that, barring a global economic and financial meltdown, the Dow should bottom well above 5,000 and the S&P Index well above 500.

It is tough to predict this year's corporate profits because of the deepening global downturn and potential likelihood of little or no earnings in the U.S. financial sector. Citigroup financial economist Steve Wieting sees $51 in operating profits for the companies in the S&P 500 this year before big write-downs, down from $66 in 2008. Based on his estimate, which is in line with the current Wall Street consensus, the S&P 500 is valued at more than 13 times projected 2009 profits.

THAT PRICE/EARNINGS MULTIPLE is in line with the lowest levels hit during most bear markets over the past 80 years. Key exceptions were 1974, 1982 and 1987, when the S&P 500 was valued at about 10 times forward earnings, according to Goldman Sachs. If stocks do get to a P/E of 10, the S&P 500 could drop as low as 500, a decline of more than 25% from current levels, and the Dow Jones Industrial Average could drop toward 5000.

This scenario seems extreme, however, because prior market lows occurred during periods of higher inflation and interest rates, decreasing the relative appeal of stocks. Treasury yields, for instance, were in the double digits in 1982, against 2% or 3% now.