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Market Outlook: Stocks Could Add 18% to Gains by Year-End

So far this year, stock market gains have been driven by price-to-earnings (P/E) ratio expansion. That could change in the second half of the year.

Earnings Growth Could Add to Market Gains

Second-quarter earnings have been coming in slightly better than expected. Nearly two-thirds of companies reporting so far have beaten expectations. Earnings per share (EPS) for the S&P 500 index are on track for 3.9% growth compared to a year ago. With growth being so slow, many analysts are worried about a potential market decline. As usual, concern grew when major indexes dropped from all-time highs last week.

After losing 1% last week, SPDR S&P 500 (NYSE: SPY) is still up about 23.5% on a total return basis in the past 12 months. Total return has come from earnings gains, dividends and an expansion of the P/E ratio. An expansion of the P/E ratio occurs when the ratio rises, and some analysts have been commenting that these market gains are of a "lower quality" than earnings gains.

An example might be helpful to explain P/E ratio expansion. If a stock earned $1 a share two years ago and traded at $10 a share, the P/E ratio would have been 10. In the last year, we can assume this stock again earned $1 a share but the stock now trades at $12 a share and has a P/E ratio of 12. All of the gains would be due to an increase in the P/E ratio, which is more formally called a P/E expansion.

Dissecting the one-year total return for SPY, we see that:

-- Dividends account for 2.9% of the total return.
-- Ignoring dividends, SPY is up 20.6% in the past 12 months.
-- Earnings growth accounts for 3.9% of the index price appreciation.
-- P/E expansion accounts for 16.7% of the total return.

Based on trailing earnings, the P/E ratio of SPY is now at 16. That is within the historic average range of 15-17.

Looking ahead, the question is whether or not P/E expansion will continue to help push stock prices up. I believe it will.

Standard & Poor's analysts expect EPS growth of 13.2% in the third quarter of this year and 25.8% in the fourth quarter. For the full year, EPS is expected to grow about 12% compared to 2012 and reach $108.50 in 2013.

To develop a price target for the end of the year, we need to determine a reasonable P/E ratio for the index given the expected rate of growth in earnings. Since 1988, the 12-month change in EPS has averaged about 8.3%. In 2013, we are expecting to see growth that is almost 50% greater than average, and that should be rewarded with a higher-than-average P/E ratio. The average range of the P/E ratio has been 15-17. With higher-than-average EPS growth expected this year, it is reasonable to expect a higher-than-average ratio of 18 or 19 for SPY.

The table below shows several possible targets:

I prefer to target the higher end of the range. Assuming companies meet expectations, the S&P 500 could trade at about 2,000 near the end of the year, a potential gain of about 18% from the current price.

If the doom and gloom forecasters are correct and a recession is on the horizon, a 20% drop in the stock market is certainly possible. However, recessions develop over time and markets generally give signals that the bull market has ended. That is not happening right now. Given the size of the possible gains, it seems best to stay invested in the stock market until a reversal is confirmed.

Could Gold Bounce Back Quickly?

SPDR Gold Shares (NYSE: GLD) was almost unchanged last week.

Gold is a unique asset class usually considered to be in a league of its own. However, gold actually shares attributes with almost all other asset classes.

With the introduction of ETFs, gold trades like stocks. Years ago, gold purchasers took physical possession of bars or coins. Transactions carried high costs and gold was truly a long-term investment. That all changed when GLD and other ETFs made gold easily tradable and reduced the costs so much that they are no longer a consideration.

This significant structural market change did not change the fact that gold cannot be valued like a stock. Gold does not provide any income to its owners and the future prospects of the metal are based on uncertain supply and demand estimates rather than operating earnings. Gold bulls believe the metal will rise in value usually because they think of it as a hedge against global economic uncertainty. Bears believe that gold is, in the words of the great economist John Maynard Keynes, "a barbarous relic" that no longer serves as an alternative to money in the modern world.

No one knows what the future holds, but in the past, gold has traded more like a commodity than a stock. One key difference between the two asset types is how tops and bottoms are formed.

In stocks, we often see a top form over time as prices trade within a narrow range before falling. Stock market bottoms often unfold in dramatic fashion with panic selling signaling the end of the bear market and a sharp reversal upward in the next few days signaling the start of the next bull market.

Commodities often show the opposite behavior. Tops are formed in a panicked fashion as investors worry they are missing the trend. This happened with gold in 2011. On the chart, the top shows as a spike high and a rapid reversal. Bottoms take time to develop as bases form over months or years.

GLD Market Outlook Chart

GLD has not formed a base and a large price move to the upside is unlikely without a base. For at least the next few months, I expect gold to be "dead money" for long-term investors. But it might be a good time to accumulate new positions as the base forms.

This Week's News

Consumers dominate the news this week. Retail sales on Tuesday will be closely watched, along with Wal-Mart's (NYSE: WMT) earnings on Thursday. Strong consumer spending would indicate the Fed might be able to taper sooner rather than later. Bad news in these reports could be bullish for stocks since it would show the economy is still struggling and the Federal Reserve can continue its easy money policies.

Market Outlook News