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Weekend Wisdom

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. Then the worst. And for good measure, I will give my prognostication of how it will all play out.


Hey Goldilocks! Best Case Scenario

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

1) 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 PE 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 muddle through economy keeps muddling along. Even perhaps heating up a notch to around 3% GDP growth. This would produce high single digit earnings growth (6-9%). That, plus the aforementioned PE expansion, could easily propel stocks to 2000 next year. And well above beyond that.

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

More . . .


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Look Out Below! 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. That would be 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 PE ratio is another important valuation metric called the "earnings yield". Right now EP of stocks is 6.8%. ($120 in S&P 500 earnings next year divided by the current level of the index at 1756 = 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 good to know the signs that would lead to a subsequent stock market decline.


And My 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 2000 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 more 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 5 years) or we do finally go sideways as we did in 2011. Simply 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 do that ;-)


What to Do Next?

If you have been predicting the ups and downs of the market well over the last few years, then stick with the strategies that are working for you. However, if you have a spotty track record, then likely you need some assistance in charting a course to better results.

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Best,

Steve Reitmeister

Steve is the Executive VP in charge of Zacks.com and all of its subscription services. His personal mission is to help investors achieve life-changing investment success by harnessing the power of earnings estimate revisions. Over the years, he has developed a full array of services to help investors do just that. Discover all of these services now to find the ones that perfectly fit your investment style. Learn more about Zacks Ultimate.

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