Back in January 2000, the Dow Jones came within 100 hundred points of the 12,000 mark. The subsequent recession knocked the index back a notch, and it wouldn’t be able to breach the 12,000 level until October, 2006 — more than six years later. Dow 13,000 would arrive by the following spring, and by that fall, the index surpassed 14,000.

It would eventually fall by half. And five years later, we’re still trying to get back to Dow 14,000.

I’ve recently been writing about my opinion that the stock market may be due for a breather after a strong three-year run, but that could well be the pause that refreshes a longer-term rally. The stars are aligning for the Dow to finally breach that 14,000 level and perhaps move up to the 20,000 mark within the next three years, which is why I am looking at any possible market pullback as a chance to reload on appealing stocks before the next upward move. You should, too…

This is not a phantom target…
To be sure, I’m instinctively leery of lofty price targets that are issued just to get attention. A few analysts recently predicted that Priceline.com (Nasdaq: PCLN), for example, will likely  hit $1,000. An especially media-savvy analyst just issued a report on Apple (Nasdaq: AAPL) with a $1,001 price target. I suppose he wins some sort of prize…

So I’m not talking about Dow 20,000 to get your attention, but to lay out the scenario in which we may get there. I don’t need to run through all the reasons we may not get there — from crippling budget deficits to volatile oil-producing nations to a good old-fashioned spike in inflation, there’s plenty that could go wrong. But there’s even more that could go right.

Of course, it all starts with profits, and what investors determine to be an appropriate valuation on those profits. As I recently discussed, profit margins have likely peaked, as the era of cost cuts has ended.

But that isn’t necessarily a bad thing. A slowly improving economy leads companies to start boosting spending in areas of the business that possess strong growth prospects. Their investments in personnel, technology, new factories and stepped-up product research can strongly stimulate economic spending.

History could repeat itself
This was precisely the backdrop that was in place in 1995: steadily rising corporate spending created a virtuous cycle that rippled throughout the economy. Corporate plans put in place in 1995 led to a profit — and stock market — surge in 1997, 1998 and 1999. In effect, the business cycle takes time to develop and only builds a head of steam after a while.



Using that historical analogy, profit growth would seem a bit subpar later in 2012, grow at a moderate pace in 2013, and really take off in 2014 and 2015.

Yet it’s foolhardy to expect a repeat of that go-go era. The advent of the Internet unlocked so much productivity and triggered so many investments that it was truly a once-in-a-generation environment. No such technology game-changer exists today.

But our era has one major positive that previous eras did not: Super-low interest rates. The Federal Reserve has kept short-term rates near zero to provide a jolt to the economy, and in coming years (perhaps sooner than people realize), the Fed will need to start nudging rates upward. Yet rates are so low that they could rise 200, 300 or even 400 basis points (2%-4%) — and a favorable backdrop for stocks would still exist. At that point, they wouldn’t be braking the economy, and they would still offer yields that are too low to rival stocks.

So many investors consider price-to-earnings (P/E) ratio, but they should be looking at it in the opposite fashion. The earnings-to-price ratio (also known as the “earnings yield“) is the best way to compare stocks and bonds. To figure a stock’s earnings yield, simply take 100 and divided it by the P/E ratio. For example, Ford Motor (NYSE: F) has a 2013 P/E ratio of 7.4, which means that the projected earnings yield is 13.5%. Compare that figure to fixed income rates, and Ford’s stock remains the clear bargain, even if rates started to rise.

How profitable and at what price?
We don’t know what corporate profits will look like, but we can make a rough guess. Let’s assume that the U.S. economy grows 2.5% in each of the next four years. That should imply roughly 5% annual sales growth for most companies, thanks to price increases and other factors. That level of sales growth should in turn lead to 10% profit growth. If we’re on the cusp of a corporate spending cycle like we saw back in 1995, as I discussed earlier, then those forecasts are likely far too conservative.

Yet the level of profit growth isn’t the main factor determining where the Dow will be in 2015. Instead, it is investors’ willingness to “pay up for growth.” Wall Street strategists say that stocks “deserve” to trade at 12-16 times earnings. But they’re wrong. As we saw in the 1990s, forward multiples actually shot through the roof — and investors don’t instinctively sell when the broader market hits a certain P/E level.

Anyway, it’s extremely unlikely we’ll see the Dow or S&P 500 be valued at nearly 25 times forward earnings, as was the case in the late 1990s. But let’s say that stocks are trading at 15 times forward earnings by 2015 and corporate profits grow at a 10% annual pace — a reasonable assumption if interest rates stay in check and investors embrace a rising U.S. economy.

Well, right there, we have Dow 20,000. Here’s the math: 



Per-share profits among the Dow Jones stood at $967 in 2011 (when negative profits are excluded). All members of the Dow are expected to be profitable in 2012, and it appears that current year profits are expected to be $1,063, but I am using a more conservative assumption of $1,025. If we use this conservative math, then it’s not hard to see the Dow breaching 20,000 by 2015.
 
[block:block=16] Risks to Consider: The risks I mentioned earlier are only the ones I can readily summon to mind. There are many other speed bumps that could impede the market’s forward momentum, though.

Action to Take –> The stock market is telling us something, but it’s not what you think.

Many attribute the recent rally to a sense that a resolution of Europe’s troubles and recent strong U.S. economic data means that we’re in the clear. That’s unlikely, and we’re bound to stumble some more before the economy enters into a sustainable growth phase. Yet it is clear that there is an awful lot of liquidity sloshing around the world, and a merely reasonable economic backdrop is reason enough for that liquidity to find its way into stocks. We don’t need a go-go era to get to Dow 20,000 by 2015, but instead a so-so era, highlighted by steady gains in corporate and consumer spending. You need to be positioned to take advantage of it.

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