Every year market strategist from the who’s who of investment firms unveil their year-end targets to the trading masses. It’s like an early Christmas present! The little people get to take a peek at what the all-knowing big wigs think is going to happen in the months ahead.

More on that in a second. But first, here’s what the seers, well, see.

Behold next year’s targets in all their glittering glory:

As of this writing the price of the S&P 500 is 2,043. So the average target of 2,224 would represent a gain of 181 points or 8.8%. Before I divulge my thoughts on the wisdom (or idiocy) of price targets, let me first school you in the art of price forecasting.

Have you ever wondered how price targets are drummed up? I mean, how do these professionals come up with the number? Do they sacrifice animals to the market gods? You know, throw chickens and goats on an altar to appease the all-powerful and receive the coveted number through revelation? Or maybe they have a skilled astronomer on staff who can divine the future from the stars. Or, I know, I know, they have a master technician in the dungeon who is the great-great-great grandson of Leonardo de Fibonnacci de Pisa. Since the blood of the man himself flows through his veins he’s a natural at Elliot Wave analysis and spits out price targets with precision.

Or not.

In reality the process isn’t near as cool (or weird, in the case of the animal sacrifices). Not by a long shot. Usually it involves a bit of fundamental analysis. The way a fundamental analyst views a stock’s price is through the lens of earnings. Like, how much is the stock trading for relative to how much money the company makes? If a company with $10 in annual earnings (EPS) is trading for $50 we would say it is trading for 5x earnings, or, in other words, it has a 5 multiple.  Do you see the formula embedded in that sentence?

You can take the multiple (M) times the earnings (E) to get the price (P).

P = E x M

Let’s pretend we’re chief market strategists.

In 2015 the earnings for the S&P 500 is estimated to be $118. Let’s assume that’s correct. So at 2,043 the S&P 500 is trading at 17 times earnings. Said another way, the S&P 500 has a P/E ratio of 17.

So that’s our starting point. Now, we need to figure out how much earnings will grow next year and whether or not the multiple investors are willing to pay will expand or contract. The first variable is a function of the growth in the economy while the second one is a function of sentiment. When investors are more optimistic about the future multiples expand as they become more and more willing to pay up for future earnings today. When they are more pessimistic about the future multiples contract as they become less and less willing to pay up for future earnings today.

Let’s say we think sentiment stays pat so we’ll keep the multiple at 17.

For earnings growth let’s go with 10%. Why? Cause I said so, son. But, since you’re so inquisitive I’ll make up a reason. With oil prices already so low we should see stabilization and a bounce back in earnings from energy companies. Additionally, Queen Yellen will guide us safely through our first rate hike appeasing the masses and economic growth will uptick nicely next year.

If we take 2015 earnings of $118 and multiply it by 1.10 (for 10% growth) we get an estimate of about $130 for 2016 earnings. Now, let’s put it all together. Take the $130 of expected earnings and multiply it by the 17 multiple ($130 x 17).

Voila!

Our year-end target for the S&P 500 in 2016 is 2,210. Now clothe that forecast in some shiny wrapping paper and a sweet sounding story and the masses will eat it up like candy.

And how might we incorporate these price targets into our trading?

Well, that’s easy, DON’T. They’re meaningless. It’s just a fun little game played every year to illustrate the folly of forecasting. Most of the people pitching these targets follow the sage advice of John Maynard Keynes:

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

Keep the target in line with historical norms. Keep it similar to what everyone else is forecasting.  Don’t be an outlier and no crazy forecasts! That way, if you’re dead wrong you can say, “boy, no one saw that coming.” Or, if you’re bullish and the market doesn’t do well simply say you were early. If it were me I’d just keep my forecast around 10% since that’s the average return of the S&P 500 since 1926 (according to Ibbotson Associates). I’d vary the prediction year-to-year for kicks and giggles. Say 5% when I want to rein in my optimism and 15% when I want to pitch something really optimistic.

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