Do Stocks Need to Rise 41% to Reach Fair Value?

With stocks poised to fall Monday, their valuations are low relative to robust earnings. One of the hardest things for investors to do is go against the tide. And buying stocks while gloom prevails is the way to profit from that pain.

One way to look at stock prices is to compare their value relative to their future earnings growth. And by that measure, stocks look inexpensive. Bloomberg reports that analysts expect a 19% rise in S&P 500 net income in 2011 -- including a 13% rise in soon-to-be-reported second quarter earnings. At 13.5 -- compared to the five-year average of 14.7, the P/E on S&P 500 stocks reflects a Price/Earnings to Growth ratio of 0.71 -- where 1.0 is fairly valued.

Projections for 2011 S&P 500 earnings suggest that business profits are just about back to where they were before the financial crisis. Specifically, $99.34 a share in S&P 500 earnings for 2011 would "almost erase the impact of the credit crisis on profits and push the rate of expansion back to its historical average," according to Bloomberg.

So what accounts for the gloomy mood towards stocks. Here are four possibilities:

• Economists are expecting slower growth. Their median forecast for 2011 U.S. GDP fell 0.2 percentage points from 2.7% to 2.5% and economists' 2012 GDP growth forecasts are down the same from 3.1% to 2.9%.
• Decelerating earnings growth forecasts. Analysts estimate that 2012 S&P 500 earnings growth will be 13% and 2013 growth will be 11%. If these estimate prove accurate, they will follow a recent pattern of slowing earnings growth -- after all 2010's Q2 earnings rose 49% while 2011's Q2 earnings are set to rise a relatively paltry 13%.
• Poor employment statistics. June 2011's jobs report reflected ongoing problems with the economy's ability to function properly. Only 18,000 new jobs were created -- 82% below expectations and the unemployment rate rose to 9.2% -- leaving 14.1 million people in search of work.
• Debt-ceiling negotiations. Widespread fear of failed negotiations to agree on an increase in the U.S. debt ceiling could be contributing to a gloomy mood.

Of the four, the one that would most dissuade me from buying stocks is the forecast of slowing earnings growth. But based on the current PEG ratio on the S&P 500 of 0.71, I would estimate that the S&P 500 would need to rise 41% from its current 1,343 to 1,892 (calculated by dividing the current S&P 500 index level by the current PEG ratio) to hit a PEG of 1.0.

And with stocks set to decline Monday morning, that valuation gap is likely to get even wider before the gloom lifts.