Will Stocks Rise 30% in 2010?

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.
Read Full Story

Can't get enough business news?

Sign up for Finance Report by AOL and get everything from retailer news to the latest IPOs delivered directly to your inbox daily!

Subscribe to our other newsletters

Emails may offer personalized content or ads. Learn more. You may unsubscribe any time.