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Bull or Bear? The Market’s Next Move

Friday - 5/24/2013, 3:06am  ET

All year long, the stock market has been batting its big green eyes at the world, drawing more and more people into its promising embrace. This is nothing new. For decades, North America's most alluring bazaar for capitalism has been making multitudes of steadfast investors wealthy, while causing heartbreak and loss for many others -- often, because of emotional decisions and the use of leverage.

But for all the headline-grabbing drama, when you get down to it, the stock market is simply an auction house for partial ownership in companies. As an owner, you share in the profits of a business through dividends and appreciation. Sometimes, the crowd is willing to bid higher and higher for a stake in these benefits, and sometimes, buyers are few and far between.

Pricing a bull market
Lately, buyers surround us, and we're witnessing history repeat itself. New market highs are earned as the population, businesses, and earnings grow. New highs can go on for years, as they did in the 1980s and '90s. Other times, the market hits a peak. and then doesn't touch it again for a decade or longer, as was the case after 2000. Where this fate is concerned, the stock market's price-to-earnings multiple is ultimately the largest determining factor.

So, where do we stand on the market's P/E today?

  • Recent S&P 500 Level: 1,667
  • S&P 500's current P/E on trailing normalized earnings: 18.6
  • Average P/E at the end of a bull market: 19.7
  • Five-decade (1949-2009) average P/E: 16.5
  • Average length of a bull market since 1962: Four years
  • Age of this bull market: Four years, two months

Source for P/E: S&P Capital IQ; average data from Bloomberg; bull-market length data from Birinyi Data.

The numbers suggest that this bull market is nearing its end. Earnings growth, or the lack of it, will almost surely determine its short-term fate.

Analysts are notoriously awful at predicting earnings busts, never seeing them ahead of time. Currently, they expect the S&P 500 in aggregate to achieve $108.52 in normalized earnings per share in 2013, up 4.6% from last year (with all the growth in the second half). Next year, they're gunning for $116.72 in earnings per share, up 7.6% from this year. 

Let's put some multiples on this. With the S&P 500 at 1,667, we have:

  • S&P 500 forward P/E on 2013 estimates: 15.4
  • S&P 500 forward P/E on 2014 estimates: 14.3

If earnings growth resumes in the second half of this year and accelerates in 2014, as predicted, then this bull market could be with us at least a few more years. In fact, although the S&P 500 trades at 18.6 times trailing earnings right now, it would need to increase substantially -- by 37% -- to reach the average bull market's expiration price of 19.7 times trailing earnings by the end of 2014 -- if earnings do indeed grow. 

But that's the big "if."

Over the past two quarters, earnings growth has been virtually nonexistent, and the average S&P 500 company's revenue actually ticked lower year over year for the quarter that just ended. In other words, resurgence in earnings growth is far from a slam dunk and, if the second half of this year disappoints, stocks will probably give back ground. After months of welcoming investors, the market could get cantankerous for the first time in a long time.

What do we do? We do what we do.
Motley Fool PRO is the Fool's only premium service with a long/short, absolute returns dictate that does not use the S&P 500 as its benchmark. Profits -- no matter what -- are our mission. With full latitude to be long or short, we've done remarkably well, (if we do say so ourselves), during one of the most uncertain times in recent market history.

As of April 30, Pro had earned 91.6% of the market's gains since our service's inception in 2008, while our real-money portfolio was only about 60% net long at the end of 2009, and about 70% net long on average since then. So, as an absolute returns portfolio carrying much lower-than-average risk, we still earned outsized returns of 10.9% annualized. The average hedge fund is nowhere close.

So, what does Motley Fool PRO do from here? We stick to our long/short, absolute returns mission. We buy great companies at good prices -- companies that should grow value over the next few years whatever the market does. We use options for income and returns whether the market goes down, heads up, or runs sideways. And we short and hedge to profit on falling prices. In other words, whatever the market does, we have some positions making us money, adding to our returns.

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