Least Surprising Prediction for 2011: Wall Street Strategists See Market Rally of 10%

According to data compiled by Bloomberg from twelve of Wall Street’s largest investment banks, strategists expect the S&P 500 index to rise by about 10% next year, which would mark the third straight year of double-digit gains for U.S. stocks. Their figures, based on operating earnings in the low 90’s for the broad index, equate to a year-end P/E of about 15 times, in-line with the market’s historical average.

Investors well-versed in market history may not feel like these predictions are all that interesting. After all, the market averages a 14-15 P/E ratio over the long term, and the mean return for the S&P 500 since it was created is about 10% per year. These Wall Streeters are clearly not going out on a limb with these estimates, which is hardly surprising given their nature to hedge their bets in an effort to protect their jobs (by rarely differing very much from the consensus view).

Since consensus viewpoints typically will not make us money, it is helpful to think about whether the odds are that the market does better or worse than these predictions. Personally, I would guess the odds are better that we see single digit returns in 2011, as opposed to a better-than-expected gain. I say that because P/E ratios are unlikely to rise given that interest rates are headed higher. Couple that with the fact that analysts consistently overestimate forward earnings growth (by a factor of nearly 2 times). A long term study by the consulting firm McKinsey has found that long-term earnings at public companies grow by about 6% per year on average, versus projections by industry analysts of 10-12% heading into any given year.

All in all, U.S. stocks are far from overvalued, but with strong earnings growth in 2011 already expected and a ceiling on multiples seemingly close by, returns in the year ahead should be decent but not fantastic, especially given that we are coming off two above-average years in a row for the U.S. stock market.