This article was written by Invesco PowerShares Senior Equity Product Strategist Nick Kalivas.

Going into 2015, investors may ask themselves: Is it possible for the S&P 500 Index to post another year of at least 10% gains? At writing, the index was on track to generate its third straight year of double-digit returns and to record double-digit gains in five of the past six years.1

The ingredients for a rally seem to be in place. Earnings are projected to grow solidly and there appears room for price-to-earnings (P/E) multiples to expand. Operating earnings per share for the S&P 500 Index are projected to be $134.89 in 2015 compared to a forecast of $117.32 for 2014, while the P/E ratio for the S&P 500 is currently below prior cycle peaks and not extreme from a historical perspective.2

Low oil prices are helping to inject purchasing power into the consumer and non-energy business sectors, and the November Institute for Supply Management (ISM) manufacturing and non-manufacturing surveys displayed healthy output with their respective production/activity components both at 64.4. 3 These factors are overlaid by the European Central Bank’s desire to expand its balance sheet through quantitative easing, and China’s move to loosen credit conditions to promote growth. Central bank action in Europe and China appears poised to offset any tightening by the US Federal Reserve.

One concern for investors may rest in the persistent elevation of the market’s P/E ratio during what will be the bull market’s six year anniversary in 2015. This may cause investors to ask a second question: Can the S&P 500’s P/E multiple continue expanding? Let’s find some answers.

There’s room for expansion … but what does that indicate?

The chart following displays historical peaks in the S&P 500’s P/E ratio on a four-quarter trailing basis going back to 1935, excluding a portion of the financial crisis between the fourth quarter of 2008 and the third quarter of 2009. (We exclude that time period because weak profits and charges to earnings led to a P/E ratio that was not very meaningful.) Keeping in mind that picking cycle peaks is a bit of an art, the chart below provides some helpful insight.

The chart allows for the following conclusions:

  • In the seven past periods examined (not including the current high), the median and average P/E ratio peaks were 22.4 and 25.8 respectively, while the lowest peak was 20.5 in 1938. This compares to the recent peak of 19.0 in June 2014. 4
  • The current cycle expansion started from a P/E trough of 13.0, so the expansion has been about 6.0. This compares to a median and average cycle increase of 14.4 and 15.7 respectively for the past seven periods.4 Therefore I believe there seems to be room for the P/E multiple to rise in 2015.
  • Although there is room for the P/E ratio to expand, expansion does not insure higher stock prices. In the seven past periods examined, the median and average price gains were 130% and 138% respectively from the low to high of the P/E ratio expansion cycle. However, in three of the seven periods, the gain was less than the current appreciation. Prices are up over 80% from the current cycle low, but only rose in the 50% region during the cycles that peaked in 1938 and 1991. Moreover, prices declined 13% in the cycle that peaked in 2008 (during the financial crisis).4

Preparing for the upside … and staying ready for the downside

In summary, history suggests there is room for the S&P 500’s P/E ratio to expand with a peak in the 21 to 22 area a seemingly reasonable target. However, the outlook for price appreciation is less compelling. It appears that investors may consider positioning their portfolios for further stock market gains in 2015, while remaining diligent about the potential for disappointment. Bluntly answering the two questions posed above: Yes double-digit gains for 2015 seem possible, and yes there is room for P/E ratios to expand. But this does not mean they will come easily or without risk and a few bumps in the road.

After a discussion with their advisor, investors may want to consider exchange-traded fund (ETF) solutions that have the potential to participate in market rallies, and the potential for downside risk mitigation. At first blush, this type of solution may seem contradictory and hard to find, but strategies that choose stocks based on low-volatility and high-quality factors may present such an opportunity. Examples include the PowerShares S&P 500 Low Volatility Portfolio (SPLV), the PowerShares S&P 500 High Dividend Portfolio (SPHD), and the PowerShares S&P 500 High Quality Portfolio (SPHQ).