Now is the magical time of year when a lot of market strategists get to pull out their crystal balls and tell everyone what level the S&P 500 will hit a year from now. We get bombarded with the opinions of gurus who did well with their guesstimate this year and amazingly, they get much more credibility because of something that is fundamentally useless. Of course, we forget or forgive their prior track records that were not stellar and just take comfort in another target for a 10% gain. Analysts used to be criticized because they offered nothing but “Buy” signals and yet, I seem to be one of the few that really isn’t impressed with market strategists that rarely, if ever, have projected a downside in their annual S&P forecast.

I do pay attention to the reasons for one estimate or another because that is useful info to evaluate. This year I am hearing a very interesting theme that keeps popping up with many strategists for justification of the 2007 market performance and that is PE Expansion. While it is true that PE multiples typically expand as a bull market ages, I am not convinced that we should be excited to hear that the majority of appreciation will not come from improving earnings and fundamentals. The consolation prize (it seems) is for all of us to be happy about paying higher prices so we can keep stocks in the black and most importantly, achieve the guru’s S&P target. One guest on Bloomberg TV quantified the relationship this way: as PE increases by 1 increment the S&P will rise 7%. Keep that in mind next year as you pay up for mediocre earnings. Maybe it will be make you feel better.

I don’t doubt that PE expansion is likely. Just consider the largest contributors to S&P performance this year and you will see a predominance of low PE sectors like energy, telecom. materials, and utilities. Meanwhile, growth stocks have not required premiums to generate appreciation in the S&P and their PE’s have moderated. In my opinion, this is the biggest reason that we haven’t heard too many people suggest that the market is overvalued. Usually, Value investors are historically the biggest source of this whine and since they have been the big winners, they will not be big whiners for some time. Unfortunately, to believe that we head higher, you have to assume that:

1. these low PE sectors will continue their 20% annualized price appreciation OR
2. growth stocks will have to inflate their multiples OR
3. some combination of the above.

I would prefer to look at earnings increases as the source of an appreciating market but I am not hearing much optimism on that front. We are struggling with many economic statistics that suggest slowed growth and a concensus of mediocre forecasted earnings. So it appears that market appreciation is a self-fulfilling prophecy for next year. It requires that you pay more - so following this logic, our success appears to be more in the hands of investors and less in the hands of the companies we are investing in.