Apparently, my prediction on Friday that stock prices have some catching up to do angered some readers, despite the hard evidence I provided.

So today, I’m dedicating some extra time to the topic and responding to the two most common objections.

First up? Readers that lambasted me for failing to note that a drop in earnings – not a rise in stock prices – could close the gap between stock prices and trailing 12-month earnings per share.

While it’s true that a drop in earnings could bring the historical relationship back inline, it’s unlikely to happen, given how analysts expect S&P 500 earnings to increase 12.6% this year and another 14.9% in 2012.

[ad#Google Adsense 336×280-IA]Only one thing can derail the forecast for double-digit earnings growth – a recession. And I’ve already explained here, here, here and here why another recession isn’t in the offing.

So, again, stocks are cheap.

But I’m not the only one that thinks so… the top brass across countless publicly traded companies does, too.

Case in point: In the first three quarters of 2011, companies spent $376.5 billion on stock repurchases – the most in four years.

“That’s a testament from CEOs, corporate managements saying they [stocks] are way undervalued and they have a positive outlook on the future,” said James Paulsen, Chief Investment Strategist at Wells Capital Management.


Ultimately, I didn’t bring up the possibility of earnings suddenly contracting because the possibility is so slim. In the future, I can bore you with such remote possibilities if you like. But I’d rather not waste your time.

Now that I’ve cleared up that issue, let’s move onto the second biggest objection to Friday’s article…

Don’t Call Me a Flip-Flopper!

A few readers believe that I should don a big fat “hypocrite” sticker on my suit jacket, instead of an American flag pin. (The nerve!)

They claim that I was advising you to be very selective when buying stocks just a few weeks ago. And that now I’m flip-flopping from a cautious stance to one of unbridled bullishness.

But that’s hardly the case. What I’m saying is that the stock market is going to head higher without all stocks increasing in price.

How’s that possible? Remember, the major market indexes are weighted by market capitalization. So the bigger companies have a greater effect on the index price. As long as these bigger companies increase in price more than the smaller companies decrease in price, the index as a whole will indeed march higher.

That’s precisely what I believe is going to happen. Why? Because the rising tide market we’ve been enjoying – whereby all stocks increase in price – has gotten too long in the tooth.

Consider: We’ve experienced the most “all or nothing” days in the market on record, according to Bespoke Investment Group. There have been 55 days this year when at least 400 companies in the S&P 500 Index all moved up or down in price on the same day.

I’m sorry. But 400-plus companies don’t share the same fundamentals. Eventually they’re going to trade based upon their respective sales and earnings growth potential.

Or more simply, given the length of the current bull market, it’s just a matter of time before investors shift their attention to only the highest quality companies. Ones, as I said last week, “reporting higher-than-expected sales and profits and raising estimates for future growth.”

Bottom line: Stock prices are undeniably cheap. That doesn’t mean every stock is going to increase in price, or by the same amount. If you want to capture the most upside potential, I recommend you be selective and focus on only the highest-quality, fastest-growing companies.

Ahead of the tape,

— Louis Basenese

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Source:  Wall Street Daily