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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.

(click to enlarge)

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.

(click to enlarge)

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.

(click to enlarge)

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.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: The Arithmetic Of A Declining U.S. Stock Market In 2014