Saturday, January 23, 2010

Dow and Euro-Dollar Forecasts

As an assignment for the first day of a class on Financial Strategy and Valuation, we were asked to forecast what the Dow and the Euro-Dollar exchange rate would be at the end of the year. I wrote my first forecast on Wednesday and, as you will see, subsequent events forced me to revise the forecast. Below is what I wrote:

Dow Jones Industrial Average at the close on March 19, 2010 = 10,560 10,120.08

Fourth quarter earnings and forecasts for 2010 earnings will continue to be optimistic through the rest of earnings season. Companies have managed to cut costs and grow profits despite decreases in revenue. Seeing an economic recovery beginning, companies believe that they can capitalize on new, revitalized cost structures and reap generous profits on the way up. Investors and analysts are likely to believe them.

In the near-term (late-January through early-February), the Dow should continue its climb. Economic reports in February should begin to bring investors back down to Earth. U.S. GDP figures will be revised down (as they were for the third-quarter) and consumer sentiment will continue to be weighed down by jobs numbers that don’t live up to expectations. Even as companies begin to rehire in light of increasing sales and maxed-out productivity, the unemployment rate will not show improvement as those who have dropped off the rolls and stopped looking for work will start again and will be included in the unemployment numbers.

The Dow Jones Industrial Average, because of the industrial components, should see the results of the recovery first, while retail and other consumer-dependant sectors will lag. The Dow has increased 2.9% from 10,428.5 to 10,725.43 at the close on January 19, 2010. The index should continue to climb in the near term and we should see a close above 11,000. After an increase of over 2.5%, the Dow should see a decrease in the neighborhood of 4% from the peak. I am projecting the DJIA will close on March 19, 2010 at 10,560.

UPDATE: After writing the above paragraphs, the Dow lost 552.45 points in three days. The sell-off demonstrates the way that unknowns can influence the market in ways that forecasts cannot predict. The announcement from China that they would look to curb lending in attempt to reduce the impact of inflation, coupled with the announcement by the Obama Administration of proposed rules that would restrict risk taking by U.S. banks, put fear into investors about the limits of recovery—despite positive earnings statements by Dow components.

A loss of more than 5% points in just a few days was not factored into my previous forecast. I cannot see the market falling too much farther within the next several days, but the mood on Wall Street has been seriously dampened. Any boost we would see from positive earnings statements, like the one this morning from GE, will be muted. The fundamentals of what I stated above should still be in play. Good earnings may stabilize the market and provide some price improvement, but economic factors will pull the market back down by the 19th of March. My revised forecast is for the Dow to close on March 19, 2010 at 10,120.08.

Euro-Dollar Exchange Rate on March 19, 2010 = $1.4445

Many counter-acting forces are currently at play in the foreign exchange market. The U.S. recovery is beginning and may soon advance at a higher rate than Europe given the risks for further turmoil, especially in places like Spain. On the other hand, our domestic recovery will be slow, possibly slower than expected. Slow U.S. GDP growth will continue to weigh on the dollar.

From the beginning of the year through January 19, the Euro-Dollar exchange rate has declined only slightly, from $1.4326 to $1.4302. These gains should be wiped away with a weakening dollar as recovery lags expectations. I am projecting a decrease of 1% in the value of the dollar against the Euro between January 20 and March 19, 2010 to $1.4445 to the Euro.

UPDATE: The Dow’s slide since the above forecast was written is not likely to have a great affect on Euro-Dollar during the next quarter. The rate should remain range-bound, despite dipping to the low end of that range this week. The Dow is more volatile than the dollar, certainly against the European currency. I do not see a reason to adjust the above forecast at this time.

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