I recently ran through a little exercise with my premium Income Trader readers, looking at the potential upside in the stock market. And I'd like to share it with you...
I'm starting with the simple assumption that the bull market will continue.
Now, there are dozens of reasons for why the bull market shouldn't continue. Yet, prices keep rising. Old traders often say, "The trend is your friend," and that has certainly been the case this year. The trend has been relentlessly up, despite weakening economic data, a potential trade war, and many other problems.
Traders have largely ignored these potential problems, and the S&P 500 gained more than 17% since the start of the year. The "up" move has been interrupted by several declines, with the most serious one (in May) pushing prices down by almost 8%.
To see how much higher prices could go, I started by looking at fundamentals.
The Fundamental Picture
Over the long run, the average price-to-earnings (P/E) ratio of the stock market has been about 17. The next chart looks at price targets for the S&P 500 based on estimates from Standard & Poor's.
To develop earnings estimates for the index, the analysts start with estimates for each of the companies in the index. They then weight those estimates so that each stock's earnings estimate carries the same weight as it does in the price index.
For 2019, analysts expect earnings per share (EPS) of $163.60 in 2019 and $183.74 in 2020. In the table below, I've shown various price targets based on P/E ratios of 15, 17, and 19.
Sentiment affects the P/E ratio. When traders are pessimistic, the P/E ratio should be below average. Bullish sentiment results in a higher-than-average P/E ratio.
The fact that prices have been rising indicates sentiment is bullish. That means it is reasonable to expect the P/E ratio to reach 19, and that means there is additional upside in the index.
Next, I looked at charts to determine targets based on the price pattern.
What The Charts Say
To find targets, I applied a relatively simple approach to chart analysis.
Chart patterns provide price targets based on the principle of symmetry. The depth of the pattern is used to find the target. This might sound simplistic, but it works more than half the time according to several studies.
Using daily data, this technique provides a target that is about 4% above current prices. The technical target is very close to the target based on earnings.
When different techniques provide similar targets, I have a high degree of confidence in the target, so it's very likely the S&P 500 will top 3,100 in the next few weeks.
For a longer-term target, I used the same type of pattern analysis on weekly data.
A 5% difference between the two techniques is not really significant. Given the bullish sentiment in the market, I expect the S&P 500 to move toward 3,500. This would be consistent with previous bull markets that end in irrational exuberance.
Some analysts will argue that this is unlikely after a 10-year bull market. But the weekly chart shows that the S&P 500 moved sideways for about 18 months. From a technical perspective, this type of price action can serve the same purpose as a bear market.
The Macro Factor
A bear market corrects the excess of the bull market. In other words, in a bull market, prices move up and often get ahead of fundamentals. The bear market decline brings prices back to a level supported by fundamentals.
Charles Dow -- the developer of the Dow Jones Indexes and founder of The Wall Street Journal -- noted back in the 1800s that sideways market moves could also realign fundamentals and market prices. Dow called sideways price action a "line." Modern analysts often call it a consolidation pattern.
No matter what we call it, the blue rectangle in the weekly chart above highlights a sideways trend. This could serve the same purpose as a bear market and could serve as a launching pad for the next move up in the stock market.
Now, there are a number of factors that could result in a bear market. The yield curve is inverted, a condition that almost certainly forecasts a recession. The chart below shows that the yield curve is inverted in both the United States and the European Union.
An inverted yield curve doesn't provide an indicator of when the recession will begin. It just means that the odds of a recession are higher than average.
Action To Take
History also shows that the stock market often races higher in the months before a recession. If history repeats, we could see a sharp rally in stocks, pushing the S&P 500 to my target level near 3,500. This would most likely be followed by a bear market, but there is significant potential upside before the next bear market.
Finally, I'd like to note that I'm a trader, and my opinion changes when the facts change. For now, I'm bullish, but that will change when my indicators tell me the economic environment and market conditions change. When that happens, you can be sure that my Income Trader readers and I will be positioned to profit.
That's because we've been making thousands of dollars in extra income each and every week since February 2013 -- and posting winning trades 91% of the time. It's all thanks to my award-winning indicator, which I developed into a low-risk trading strategy that anyone can use. You can learn all about it right here.