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Why a S&P/TSX at 14,400 a year from now is wishful thinking

When a market gets beaten down as far as Canada's stock market has this year, it's easy for a "there's nowhere to go but up" attitude to filter into stock analysis. But the equity analysts may be taking it too far.

National Bank Financial economist Marco Lettieri says that if you combine the consensus 12-month stock-price forecasts from analysts for all the companies on the S&P/TSX composite index – a so-called "bottom-up" price forecast for Canada's benchmark stock index – you come up with more than 14,400 for the index a year from now. That's 26 per cent above Thursday's closing level of 11,408.

That would be great news for investors – if it were realistic.

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"We believe that consensus estimates are too optimistic for the next 12 months," he wrote in a recent research note.

It's possible – on paper

Long-suffering investors might take issue with Mr. Lettieri's negativity. After all, the S&P/TSX is down 10 per cent since the end of February, 15 per cent from last July, 20 per cent from its peak of April, 2011. The index is priced at less than 12 times the forecast earnings per share for the next 12 months, well below its historical norm of about 14 times. A return to this normal price-to-earnings valuation would add more than 2,000 points to the index all by itself – without any growth in earnings.

By Mr. Lettieri's own calculations, "the market would need a 10-per-cent increase in earnings accompanied [by] a 15-per-cent expansion of the P/E ratio" to reach the bottom-up 12-month target of 14,400. A 15-per-cent rise in the P/E would still leave it under 14, so it's far from unrealistic. And 10-per-cent earnings growth is hardly outrageous – S&P/TSX profits have grown by more than that in six of the past 10 years.

"This scenario would be possible under normal conditions," Mr. Lettieri acknowledged. But these are far from normal conditions.

Headwinds are powerful

The financial-market uncertainties stemming from Europe's debt and banking crisis have fuelled an aversion to risk assets, particularly stocks and commodities. "This has resulted in a significant increase of the equity risk premium," which is why the P/E valuations are depressed, he said. As long as Europe remains in doubt, this is unlikely to unwind.

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The same de-risking trend, coupled with a weakening global growth outlook, is clobbering commodity prices. Yet the equity analysts' bottom-up price targets imply that the S&P/TSX's heavily weighted energy and materials sectors are going to supply the market's biggest price gains in the next 12 months. Mr. Lettieri said oil prices would need to jump 32 per cent, copper 24 per cent and gold 14 per cent in the next year to justify those bottom-up price forecasts.

In global economic and financial conditions that "are more likely to get worse before they get better," that looks more far-fetched every day, he said.

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