With the economy struggling after the worst recession on record, an ongoing debt crisis in Europe, a brewing trade war with China, a collapsing dollar, and yet another mortgage scandal, I'm going to make the case that stocks could be at all-time highs by this time next year.
My prediction doesn't require a particularly rosy view of the economy -- just simple arithmetic.
Let's start with this: $103 per share. That's the record high for expected operating earnings for the S&P 500. It was set almost exactly three years ago. Not coincidentally, the S&P 500 reached its all-time high (1565) around the same time.
Now another number: $63 per share. That's the low for expected earnings for the S&P 500, set in May 2009, a month before the bottom of the recession, but two months after the bottom for stocks.
The 39% drop from $103 to $63 is quite a tumble. It's not the worst earnings drop in history, but it is the worst since 1938. And it happened even though the gross domestic product fell only 1.1% over the same period (not adjusted for inflation).
Now, a third number: $92. That's where expected earnings per share are right now. That's a huge gain off the low -- an amazing 46%. That stellar gain took place while GDP grew only 5% (again, not adjusted for inflation, and assuming that third-quarter growth was the same as second-quarter growth).
As I discussed in this column a couple of months ago, this kind of earnings jump happens because of "operating leverage." When a recession hits, earnings are hit far worse than the overall economy. And when the recovery begins, even a modest recovery, earnings come surging back. It's as close to a law of nature as you're ever going to find in investing.
All it would take now for earnings estimates to return to all-time highs would be another 12% increase. That seems pretty much inevitable over the coming year, unless the economy lapses into another recession (which, as I explained here recently, it's definitely not going to do). If 5% GDP growth can trigger a 46% earnings recovery, it doesn't seem like that much of a stretch to think that we could get the further 12% earnings recovery we need, even if GDP growth is downright mediocre.
