Last Updated Jan 12, 2010 11:01 AM EST
We'll use the S&P 500 as our proxy for the stock market, since it's the most widely accepted index.
Earnings Estimate. The first step in predicting how the stock market will do for the year is to come up with an earnings estimate for all the companies that make up the S&P 500. Basically, you have to predict how much money you think all these companies will earn in 2010.
- No one person can make estimates for all 500 companies in the index, so market gurus rely on analysts' estimates. Analysts follow specific companies and come up with estimates for the earnings these companies will generate over the next year.
- Stock market gurus then use those estimates in making their predictions about total earnings for all the companies in the index.
- The problem is that analyst estimates are often wrong, particularly during periods of economic volatility. Think about it, to predict how much money just one company will earn for the year requires you to estimate hundreds of variables, and then try to account for things you have no control over, like the housing market, commodity prices, inflation, interest rates, tax rates, terrorism, and political instability, just to name a few. Then different analysts come up with different estimates, which also complicates things.
- But hey, if you want to predict the stock market, you've got to eventually settle on the earnings estimates you want to use.
- Once you have your estimates, you get an estimated earnings per share on the S&P 500 index.
- Let's assume right now that the estimate is $55 per share, which is what S&P is showing on their website for what's called the "as reported earnings, using a top down approach."
The next step is to estimate how much investors are willing to pay for each dollar of earnings that the index generates. This is called the Price to Earnings multiple (PE) that you often hear investors talk about.
Over the last 100 years, the average P/E ratio is about 16, so that means on average investors have paid $16 for every dollar of earnings. At that rate, with $55 of earnings and a multiple of 16, that puts the index value at 880, which is about 23% lower than the current index value of 1,140.
PE ratios can fluctuate wildly depending on how investors feel about the future. At times, the ratio has been below 10 and at other times above 40.
- Think about it this way, on the same earnings of say $55 per share, if investors only paid a multiple of 10, the index is at 550 (about a 50% decline from its current value). But if investors will pay a multiple of say 25, then the index is at 1,375, or 21% higher than its current value. Mind you, the earnings are the same, it's the multiple that's changing. Right now, investors are willing to pay a multiple of about 21, which is higher than the historical average.
Bottom line. While we can crunch reams of earnings data to come up with scientific looking stock market predictions, for any given year the stock market's value is highly dependent on what mood investors are in; and you can't put that into a spreadsheet.
Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and online.
Watch the CBS Moneywatch interview on Your Money Ratios.