How High Will Stocks Go?

This article was originally published by Zacks.com.

Stocks have rallied over 160% from the depths set in March 2009. And this year alone we are up another 23%. That begs the question: How high will stocks go?

I will explore that topic by first looking at the best-case scenario; and then the worst. And for good measure, I will give my prognostication of how it all will play out.

Best-case scenario

Plain and simple, the bull rally will stay in place until one of two things happens:

1. A recession appears on the horizon.

2. Stocks become ridiculously overvalued and the bubble needs to be burst (like in 2000).

Right now the economic data shows no signs of a recession in the air — so no problems there. And, yes, stocks are getting pretty fairly valued these days. However, history shows that most bull rallies don't end until way past fair value … what you might call “fully valued.” That could be at a price-earnings (P/E) ratio of 18-20. Whereas the S&P is only trading at 15x next year's earnings estimates.

So the best-case scenario is that the economy keeps muddling along. Perhaps it will even heat up a notch to around 3% GDP growth. This would produce high single-digit earnings growth (6% to 9%). That, plus the aforementioned P/E expansion, could easily propel the S&P 500 to 2,000 next year. And well beyond that.

Long story short, you stay fully invested in this market until a recession appears eminent or stocks become bubblicious.

Worst-case scenario

The previous section provided the two main elements (recession and valuation) that would lead to the worst-case scenario and full-blown bear market. Note, the average bear rips out 34% from stock market valuations. That is actually a good scenario if you see it coming and get short in time to profit from the move.

However, there is one other thing that could be the harbinger of the next bear — a dramatic rise in interest rates.

At first it would be good for stocks as investors would lose more money in bonds and switch to stocks as a more attractive alternative. Yet, the higher rates go, the more it calls into question the true value of stocks.

Note that the inverse of the P/E ratio is another important valuation metric called the “earnings yield” (E/P). Right now the E/P of stocks is 6.8%. ($120 in S&P 500 earnings next year divided by the current level of the index at 1,756 equals 6.8%.) That is attractive versus the 2.5% yield on 10-year Treasuries as the average historical spread of these investments is 3%.

So now imagine that there is a whiff of inflation in the air. Or our politicians botch up our debt situation. Or the Fed tapers too much too fast and rates start soaring back towards 4% or higher. Now stocks won't look so attractive, leading to a decline.

I do not fear any of these nasty scenarios playing out at this time. But it’s good to know the signs that would lead to a subsequent stock market decline.

And the crystal ball says...

Previously, I was predicting that 2014 was setting up to be a sideways year for the market because of the tremendous gains to date. Yet, now I think that a 10% rise towards 2,000 on the S&P is more likely because there are still too many investors overloaded in poor performing cash and bond investments. They need to fully hop on the stock bandwagon … and for them the signal to get on board is headlines reading "Stocks Make Record Highs!"

Then in 2015 we are either ripe for the next recession (because they come on average every five years) or we do finally go sideways as we did in 2011. It's hard to rally so strongly year after year. It's like eating a massive Thanksgiving dinner. You need some time on the couch to digest it all. Few can go back day after day to do it again. (Or at least they shouldn't.)

The information supplied above by Zacks Investment Research Inc. contains opinions based on factual research which may or may not be accurate. Neither Zacks nor Intellisphere will assume any liability for losses from investment decisions based on this information.