Wall Street always has a logic as to why markets should go up. Here are the reasons that we will hear in the next few months:
a) Stocks are very cheap, they are only trading at xx trailing (currently 12) earnings - which is the lowest it has been in last 25 years. Note however, the stress on trailing rather than forward earnings. When the bull market was on, analysts used forward earnings - because next year number was forecasted to be higher than this year. But now, when next year number is likely lower, analysts are using trailing earnings. The game is to always use the higher E, and come to a low PE.
b) Stocks bottomed at xx trailing earnings (8x, 10x etc) in the last bear market and so if things become really bad, there is only a 20% downside from here. Really. Right now, we are talking of peak trailing earnings on 2007 - not trough trailing earnings. Stocks bottomed out at low multiples of trough trailing earnings.
One of the most insightful comments came from this guy on CNBC recently. He said that there was one quarter in the 1970's when annualized earnings came in only at $5 for Dow Jones Index. That qtr, the theoretical PE of the index was close to infinite.
c) Stocks always turn up before economy turns up. Typical bear markets end when recession is xx% (40%, 50% etc) through. Since the recession started in Nov 2007 and will likely last till Dec 2009, we will be there soon. But, excuse me, till 2 months ago, we were debating whether we are in recession or not. So how is it suddenly that recession started last year.
That is not to say that there wont be massive bear market rallies, like the one which has started now. I wouldn't be surprised if we go up 20% from here in US before the year ends. However, I am not buying the argument of buying en masse before the economy turns, because nobody knows when that happens. Wasn't 2H08 supposed to be the recovery time?
S&P EPS for next year is around $50-$70, depending on the strategist. Put an appropriate multiple, and we can come to an index level. Don't forget that the corporate bond spreads are all time highs, so discount rate (WACC) for stocks needs to go up and multiples need to come down. Many analysts are using WACC's that are below the corporate debt yields of the same company - that's wrong - unless the assumption is that spreads are going to narrow.