Now that January has disappointed, market forecasts for 2014 have become less favorable (i.e. "January Effect"). Last month I forecast a 16% loss in 2014 while others were forecasting gains. I'm not saying "I told you so" but I would like to add some more justification for my prediction.
As shown in the next graph, Wall Street is forecasting gains of up to 13.61%. Let's look at the bases for these forecasts.
There is a formula that can help us frame our own outlook, and it can also be used to infer the underlying assumptions in expert forecasts. It goes like this:
Return = Dividend Yield + (1 + Earnings Growth) X (1 + P/E expansion/contraction) - 1
You can use the formula yourself, plugging in your estimates of earnings growth and ending P/E. For example, the following table uses the formula to peek into 2014. The cell highlighted in yellow - earnings growth of 6% and an ending P/E of 15 - is the average long-term situation. In other words, if 2014 is "average" we'll see a 16% loss next year. You can also see that the Wall Street forecasts imply a constant P/E at 20.
Now let's integrate inflation outlooks for 2014 to examine where P/Es might go. There is debate regarding deflation or inflation in 2014, with few in the middle at constant single-digit inflation. What most don't realize is that inflation extremes - up or down - lead to contractions in P/E, as shown in the next picture.
So what does this mean? If your outlook for inflation in 2014 is either increasing or decreasing, your outlook for stock prices should be declining.