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Eddy Elfenbein submits: Today, I’m going to try to do the impossible: I’m going to defend the bull market.

Now, now. Before we get too carried away, I’m not going to make any outlandish predictions for the Dow or Nasdaq. Sorry, no forthcoming book Dow 13,469.12 for me. I’m afraid I’m not any good at the whole predictions racket. But what I want to do for you, dear reader, is show you how the market ought to be analyzed.

I’m afraid dissecting the market the market is a lot more boring than throwing out random numbers, which, for reasons that elude me, is often followed by macho posturing. (Boo-yah!)

Investing analysis isn’t about predicting some number, and waiting to see if we hit it. We can all have a cheap and easy laugh at market professionals who get it wrong. Not only will I get it wrong, but that forms the foundation of my investing philosophy. You see, one of the best things about investing is that you don’t need to be right. You can be totally 100% wrong on lots of things. You can be wrong on the economy. Wrong on the Fed. Wrong on interest rates. Lots of things. But you can still be a good investor.

I’ll give you a quick example. One of my stocks on my Buy List, SEI Investments (SEIC), is up over 50% this year. If I had predicted that, you would have thought that I was some crazed marijuana addict. I didn’t predict where it was going, but I based my recommendation on reasonable assumptions.

OK, let’s read that last sentence again: I didn’t predict where it was going, but I based my recommendation on reasonable assumptions. In the investing game, we don’t need to be right, but we do need to be reasonable.

bullWhat we need to do is compare the stock market with the bond market and make some reasonable assumptions of what could happen. The name for this is risk analysis. We’re not saying what will happen, we’re looking at what could happen.

When I say risk analysis, we want to look at the potential upside and downside. I have to stop the discussion and mention that what may be right for me, may not be right for you.

Here’s an example. Let’s say that the market has a 50% chance of rising 30% over the next 12 months, and a 50% chance of losing 3% over the next 12 months. That’s a bet I would happily make. I understand the odds. I think they’re in my favor. I understand and can face the consequences. Other people might not feel that way. But the fact is, we all know what the rules of the game are. As investment analysts, our goal is to find out what the rules are.

Now let’s look at the match-up. In this corner, we have short-term interest rates (mixed boos and cheers). The one-year Treasury is currently yielding 5%. Honestly, that’s not bad. Put it this way. You can turn off the TV, ignore the market for the next year and make an easy 5%. That’s over 600 Dow points. It would bring your portfolio up to the equivalent of Dow 12,800.

I think that’s an attractive option. The best part of it is that it’s low risk. The bonds are back by the full faith (cough) and credit (cough, cough) of the United States (wheeze) government. No more worrying about the Fed or options scandals or if the president of Wackistan suddenly decides he wants to be Hitler 2.0.

In this corner, we have the stock market (loud and prolonged boos). So what we want to find out is if the Dow has a shot of beating 5% for the coming year.

Over the last 40 years, stocks have beaten bonds by an average of 1.7% a year. That’s what you get for the “uncertainty” of owning stocks. Interestingly, that number has been surprisingly consistent. For our purposes, we’re going to ignore the risk premium because we’re going to try and explore our way out of those uncertainties.

First off, the dividend yield on the S&P 500 is 1.8%, so we’re already more than one-third of the way to our 5%. Now we want to see if the market’s earnings can grow by 3.2% over the next year. Given that inflation is close to that level, all we want to see is if real earnings will grow at all.

Currently, operating earnings for the S&P 500 are expected to grow by 10.1% for the next year (Q4 and the first three Qs of next year). Of course, that’s just today’s estimate. I should add that earnings growth has been impressive recently, but the rate of earnings growth has been slowly easing up, or decelerating if you want to sound cool. Personally, I think that earnings growth is closer to leveling off than going into a steep decline, but we just don’t know yet.

Of course, the housing market is falling apart like the Yankees. Also, a negative yield curve has often foretold a rough earnings environment. But this earnings season is looking good so far. I certainly realize that 10.1% growth will not be exact, but as of now, there’s no hard evidence of an earnings recession in the immediate future.

Predicting earnings growth is not easy; it's notoriously volatile. Over the past several years, the standard deviation of yearly earnings growth has been 13.7%. That’s pretty wide and it should remind us to be very cautious about making any silly predictions. We're less than one standard deviation from an earnings recession.

Once again, we don’t need to be right, but our assumptions need to be reasonable. If earnings growth is 10.1% with a standard deviation of 13.7%, then that means that earnings have a 69% chance of beating 3.2% (i.e., the one-year Treasury minus the S&P dividend yield). So far, I like those odds.

Now I see that some of you are ready to jump out of your seats and yell about the market’s P/E ratio. Hooold on. Of course, earnings can do well and the market might not see any of it because earnings multiples contract.

For the most part, I believe that it’s best to assume a neutral valuation environment. Predicting earnings multiples is very tricky stuff, and they don’t often behave as we might like. Also, even if P/E ratios work against us, we can still make money. After all, earnings multiples have declined for much of this bull market.

The closest variable that P/E ratios follow is long-term bond yields. But event that relationship isn’t so easy. For many years, the earnings yield (the inverse of the P/E ratio) was less than the 30-year Treasury bond. Not anymore. For the last three years, the earnings yield has climbed higher and higher above the 30-year yield.

Does this suggest that P/E ratios are way too low? Possibly. But I think another explanation is that the long-end of the yield curve is unnaturally low. This goes back to Mr. Bernanke’s conundrum. So this means that our best guide to P/E ratios is either not working, or it’s indicating that ratios should be much higher.

Even if lower P/E ratios erased stock's gain relative to bonds, that would mean that the S&P’s P/E ratio would have to fall from roughly 16 today to 15 one year from now. It certainly could happen, but it would mean that multiples would then be the lowest in over a decade. Once again, the risk analysis leans towards stocks. And we can’t forget that the P/E ratio could expand. There's always the risk of missing out on a big gain. On average, the market’s total net gain comes on just one day in 100.

I also want to look at some indicators of sentiment. This is an unusual bull market because as the bull has charged on, earnings multiples have fallen and dividend yield have climbed. I can’t think of another bull market like that. Also, value stocks have outperformed growth stocks. When a market gets frothy, growth stocks typically take value stocks out to the woodshed. Also, the Nasdaq is less than 20% of the Dow. That’s about the long-term average. When the crowd gets greedy, the Nasdaq often climbs well above 20%. Six years ago, it got above 50%.

To conclude: My assumptions could be totally wrong, but I think they’re reasonable. I think it shows us that the odds lie in favor of the S&P 500 beating the one-year Treasury yield.

Source: Defending This Bull Market