Most of the movie up to the time they go to the spooky show is a masturbatory fantasy/dream/hallucination of Watts's character. It's how her Hollywood dreams should have gone...acing the audition, getting the girl. The "reality" is shown after that in the disjointed scenes...it seems she lost the girl to the scummy director, everything went badly for her in Hollywood, and she eventually hired a hit man to kill the girl ("this is the girl").

Many elements from the "reality" show up in the "dreams" in distorted form. Eventually Watts is overcome with guilt and horror at what she's done and become, and commits suicide.

One of my Lynch friends would hate this explanation because Lynch shouldn't and can't be explained, even though Lynch says Mulholland is one of his few movies that does have what he believes to be a logical plot. One of my non-Lynch friends discussed it for 2 hours in a "Yale film class" which is apparently completely ****ing brain-dead, because their final word on the subject is that the entire movie (all of it) is a dream (with "Freudian imagery" to boot!). Otherwise how would you "explain" things like the miniature old people (which scared me more than anything else ever up to that time btw) showing up in what is supposed to be real-life? I guess any film that is the slightest bit surreal is "all a dream"? Tilts me tremendously.