Reasonable returns in 2013 would send the S&P 500 toward, and possibly past, its record close of 1,565 reached in October 2007.
A mid-year rally in 2012 pushed stocks to their highest in more than four years. Both the Standard & Poor's 500 and the Dow Jones industrial average are on track for strong gains in 2012. Those advances came despite uncertainty about the outcome of the presidential election and bouts of turmoil from Europe, where policy makers finally appear to be getting a grip on the region's debt crisis.
"As you remove little bits of uncertainty, investors can then once again return to focusing on the fundamentals," says Joseph Tanious, a global market strategist at J.P. Morgan Funds. "Corporate America is actually doing quite well."
Although earnings growth of S&P 500 listed companies dipped as low as 0.8 percent in the summer, analysts are predicting that it will rebound to average 9.5 percent for 2013, according to data from S&P Capital IQ. Companies have also been hoarding cash. The amount of cash and cash-equivalents being held by companies listed in the S&P 500 climbed to an all-time high $1 trillion at the end of September, 65 percent more than five years ago, according to S&P Dow Jones Indices.
Assuming a budget deal is reached in a reasonable amount of time, investors will be more comfortable owning stocks in 2013, allowing valuations to rise, says Tanious.
Stocks in the S&P 500 index are currently trading on a price-to-earnings multiple of about 13.5, compared with the average of 17.9 since 1988, according to S&P Capital IQ data. The ratio rises when investors are willing to pay more for a stock's future earnings potential.
The stock market will also likely face less drag from the European debt crisis this year, said Steven Bulko, the chief investment officer at Lombard Odier Investment Managers. While policy makers in Europe have yet to come up with a comprehensive solution to the region's woes, they appear to have a better handle on the region's problems than they have for quite some time.
Stocks fell in the second quarter of 2012 as investors fretted that the euro region's government debt crisis was about to engulf Spain and possibly Italy, increasing the chances of a dramatic slowdown in global economic growth.
"There is still some heavy lifting that needs to be done in Europe," said Bulko. Now, though, "we are dealing with much more manageable risk than we have had in the past few years."
Next year may also see an increase in mergers and acquisitions as companies seeks to make use of the cash on their balance sheets, says Jarred Kessler, global head of equities at broker Cantor Fitzgerald.
While the number of M&A deals has gradually crept higher in the past four years, the dollar value of the deals remains remains well short of the total reached five years ago. U.S. targeted acquisitions totaled $964 billion through Dec. 27, according to data tracking firm Dealogic. That's slightly down from last year's total of $1 trillion and about 40 percent lower than in 2007, when deals worth $1.6 trillion were struck.
M&A deals are good for stock prices because the acquiring company typically pays a premium for the one it's buying.
Falling interest rates also set off a rally in the bond market. Concerns about swings in stock prices prompted investors to switch money out of stocks and into bond funds. If investors decide that the bond rally may be nearing an end, that flow of funds may be reversed, providing a support for stocks.
"Equities are the best house in a bad neighborhood," says Cantor's Kessler. "Bonds are, not priced to euphoria, but they are definitely rich compared to equities right now."
Not all investors are as sanguine about the prospects for 2013.
The rally in stocks in 2012 had less to do with company earnings and the economy and more to do with monetary stimulus from the Federal Reserve and other central banks around the world, says David Wright, a managing director and co-founder at Sierra Investment Management in Santa Monica, Calif.
Federal Reserve Chairman Ben Bernanke announced Sept. 13 that the central bank would add another round to its bond-purchase program, known as "quantitative easing" on Wall Street, which is intended to lower borrowing costs and boost growth. Speculation that more stimulus was coming had pushed the S&P 500 index to 1,466, its highest close of the year, a day earlier. The Dow peaked for the year at 13,610, Oct. 5.
"The Fed has done everything it can do and is probably pretty close to having used its last bullet," said Wright. "It's been a good year for stocks, but we think that's an artifact of monetary stimulus."
This year's peaks in the Dow and the S&P 500 won't be surpassed in 2013 and stocks may even slump in the first quarter, as investors lower their earnings expectations, Wright says. The money manager also says that any budget plan, regardless of the details, will be negative for stocks as it will involve higher taxes and lower government spending.
Wells Fargo Securities market analyst Gina Martin Adams also says companies will struggle in the first half of the year as the economy flirts with recession. Export growth is slowing and policymakers are struggling to come up with a plan to reduce the budget deficit.
The bank recommends that investors add to their holdings of financial and utilities stocks because low rates should help support steady earnings growth in the early part of the 2013. Financial stocks advanced 25 percent in 2012, making them the best performing industry group in the S&P 500. Utility stocks fell 3.4 percent, the worst performing of 10 industry groups in the index. The bank says investors should reduce their exposure to so-called consumer discretionary stocks, such as hotels and restaurant companies, because consumer spending will likely take a hit next year as taxes rise.
With a backdrop of historically low interest rates and an economy that still needs to address its fiscal imbalances, investors should remain realistic about the returns they are going to get from the stock market, says Darell Krassnoff, managing director at Bel Air Investment Advisors.
"Things are getting better, not worse, but you have to have reasonable expectations," Krassnoff says.
(Copyright 2012 by The Associated Press. All Rights Reserved.)