Will Stocks Rise 30% in 2010?

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The week between Christmas and New Years is always a good time to look at market predictions for the year ahead, and in 2009 many forecasters are feeling optimistic. An analysis in Wednesday's Wall Street Journal predicts S&P 500 earnings growth between 21% and 30% in 2010.Strong earnings growth is particularly interesting if you believe that there is a high correlation between stock prices and profit growth. One such theory that I find intriguing is that a stock is cheap if its Price/Earnings ratio (P/E) is less than its earnings growth rate. Additionally, stocks are fairly valued if stocks' P/E ratio equals their forecast earnings growth rate. Applying this approach to the numbers reported in today's Journal suggests that stocks could rise more than 30% in 2010.

Here's how: The Journal suggests that earnings per share for all of the companies in the S&P 500 will rise between 21% and 30% to $72.52 (based on a consensus top down forecast of 18 strategists), or $77.54 using a so-called bottoms up forecast.

To get from there to a forecast value for the S&P 500, I multiply that earnings forecast by a P/E ratio. One ratio that might be reasonable to use is the current value of the S&P 500 divided by 2009 earnings per share for all 500 companies in the index.

This so-called trailing P/E is 18.9 -- $1,126 (the S&P 500's closing value on Tuesday) divided by 2009 S&P 500 estimated earnings of $59.65 a share. If I apply that P/E to the 2010 earnings forecast, I get 2010 levels for the S&P 500 between 1,371 (18.9 x $72.52) and 1,466 (18.9 x $77.54). If this forecast is correct, the S&P 500 will rise between 21% and 30% in 2010.

But if you think that the market P/E should equal the earnings growth rate, stocks could rise even more, depending on your assumptions. For example, the 21% earnings growth rate would imply a 35.3% rise in the S&P 500 in 2010. (To get that I multiplied a P/E of 21 by the $72.52 earnings forecast.)

If it makes sense to assume a link between earnings growth and stock prices, then stocks are likely to outperform 2010 bank deposit rates -- which will probably stay below 2%. So it might make sense to consider investing more in an efficiently managed stock index fund.
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