Dow Jumps 80, But How Much Higher Can Stocks Climb?

On Thursday, the Dow Jones Industrials continued their winning ways, gaining 80 points as of 12:30 p.m. EST. But even as short-term traders focused today on lower numbers of unemployed workers filing for jobless benefits, investors with a longer time horizon are trying to figure out just how much further the Dow can climb after nearly five years of impressive gains.

Valuations on the rise
After a nearly 150% jump for the Dow in the past five years, many investors are becoming understandably concerned about market valuations. Admittedly, earnings have risen dramatically from the depths of the 2008 recession and the financial crisis, and so rising net income has kept earnings multiples from climbing as much as the Dow's gains might suggest. According to Wall Street Journal data, the Dow Industrials now trade at about 16 times their collective earnings. Broader stock market indexes point to somewhat higher valuations, with the S&P 500 carrying a P/E of about 18 and the Nasdaq 100 fetching nearly 22 times trailing earnings.

Charging Bull in Bowling Green Park, near Wall Street. Photo Credit: Wikimedia Commons.

Yet analysts recognize that focusing only on the most recent 12 months of earnings can be misleading. For that reason, many investors use a cyclically adjusted measure of earnings, with one popular method involving going back 10 years and taking average annual earnings in an attempt to smooth out business-cycle fluctuations. By this metric, according to data gathered by longtime Fool community member Doug Short, the S&P is valued at between 24 and 25 times cyclically adjusted earnings, almost double the 13 times earnings at the market's 2009 lows.

Getting toppy?
The big question for the sustainability of the bull market is whether aggressive estimates for earnings growth in 2014 will actually pan out. According to forward estimates, S&P earnings could climb by 20% this year, as corporations continue to ride low interest rates and expanding profit margins. Clearly, a 20% jump in earnings supports a 20% rise in stock prices under the conventional trailing-earnings valuation method, and it would have a smaller but still significant impact on the 10-year cyclically adjusted method as well.

Yet many companies have faced the challenge of trying to raise earnings even as revenue has sagged. Investors expect IBM to deliver 10% growth in earnings per share this year, yet the company could see overall revenue fall compared to 2013. IBM has invested huge amounts in stock buybacks to reduce share counts and boost earnings per share, but shareholders haven't given the tech giant credit for its moves, having sent the stock down about 10% over the past year. Oil giants ExxonMobil and Chevron face similar challenges in light of sluggish energy prices and production headwinds.

Meanwhile, even those companies that are growing are counting on continued margin growth. Visa , for instance, expects 17% annual earnings growth this fiscal year and next, despite analysts' estimates that put revenue growth closer to 10%-11%. Home Depot is in a similar situation, with earnings growth pegged at 15%-18% over the next two years despite expectations for revenue growth of just 4%-5% annually. With previously favorable factors on the margin front, including the direction of interest rates, starting to reverse themselves, it might not be realistic for investors to assume continued margin expansion.

Still, as we saw during the 1990s bull-market surge, euphoric markets can climb well beyond even the most optimistic predictions. Indeed, with past cyclically adjusted P/E ratios having risen above 40 in 1999 and 2000, bulls will argue that the Dow has plenty of room to rise before it reaches unprecedented valuations.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Home Depot and Visa. The Motley Fool owns shares of International Business Machines and Visa. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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