Stock prices have stumbled out of the gate during the first few days of this year.  One reason is profit taking after a very strong fourth quarter.  Another is that many assumed stock prices would rise in January and might have bought in December to catch the full surge.  When January arrived, the buyers already had bought. 

A chorus of cautious stock market forecasts also upset some investors.  Those forecasts contained concerns about rising inflation from a weak dollar, high energy prices, or rising cost pressures as productivity gains begin to slow. 

As a result of those pressures, profit margins were projected to decline while ten year government bond rates were expected to surge. 

Let’s say that inflation continues in 2005 at the 3 percent rate that occurred in 2004 as measured by the CPI.  If inflation adjusted economic growth is 3.5 percent for 2005, a standard forecast, but profit margins are beginning to erode, then operating profits might grow only 5 percent. 

Under those conditions, the 10 year government bond could rise in yield to more than 5.5 percent.  This is caused by the combination of 3 percent for inflation, another 1.5 percent for the time preference of money (you need to be bribed to part with purchasing power), and an additional 1 percent to compensate for fluctuating interest rates faced by 10 year bond investors. 

According to a model popularized by the Federal Reserve, stocks are undervalued if the pennies of earnings per dollar of stock price are higher than the yield on the ten year government bond.  Conversely, if earnings per dollar of stock price are lower than bond yields, you probably should choose bonds over those expensive stock prices. 

In the third quarter of 2004, the latest data available, earnings per dollar of stock value were 5.17 cents.  The ten year government bond was yielding about 4.25 percent.  Therefore, the subsequent stock market rally should not have surprised investors.

Profits in the fall grew slightly faster than even the robust growth in stock prices.  As a result, I believe earnings probably are about 5.3 cents per dollar of stock value.  Again, at current interest rates, stocks remain sharply under-valued.   

However, if operating profits grow only 5 percent, then earnings at current stock prices rise only to 5.55 cents.  If the ten year bond falls until its yield is 5.5 percent, then there is no room for rising stock prices.  Indeed, one Wall Street forecast reached just that conclusion for this year (although they assumed the 10 year yield would reach 6 percent as inflation accelerated). 

I have just demonstrated how a forecast of no change in the stock market can be made despite continued job growth and economic expansion.  Now how realistic is that forecast. 

First, to replicate last year’s 3 percent inflation, energy prices would need to add another 1.5 percentage points to underlying inflation or underlying inflation might need to double in a single year.  While energy prices might add a little (but not in my forecast) and underlying inflation should rise, the combination of changes needed to preserve 3 percent inflation in 2005 are very unlikely. 

Second, a weak dollar adds to domestic pricing power.  If productivity growth slows, cost pressures may increase.  Nevertheless, costs would need to rise sharply to reverse the growing profit margins of the past few years.  I actually see slightly further enhancement of profit margins. 

Third, if inflation is well below 3 percent, then the 10 year bond yield could remain well below 5.5 percent. 

My forecast generates a 10 percent increase in operating profits.  At current stock market prices, that puts earnings at 5.8 cents per dollar of stock value. 

If the 10 year yield remains below 5 percent, as I expect, then there is substantial room for stock prices to rise.  The math actually suggests that a 16 percent gain in stock prices would be needed to drop those earnings to my projected yield on the 10 year bond.