Bank of America Merrill Lynch Normalized equity risk premium.

Strategists at Bank of America Merrill Lynch on Monday raised their 2013 target for the S&P 500 /quotes/zigman/3870025 SPX  to 1,750 from a previous target at 1,600, with expected earnings growth set to take over the heavy lifting from multiple expansion.

The term, multiple expansion. refers to a situation in which the price/earnings, or P/E, ratio rises because investors are increasingly willing to pay more for a dollar of earnings. That phenomenon, rather than earnings growth, was the main driver of the equity rally in the first half of 2013, wrote analysts led by Savita Subramanian in a note detailing the revised call. The forward P/E multiple   the price-to-earnings ratio based on forecasted earnings  on the S&P 500 expanded from a price of 12 times earnings to 14 times earnings over that period.

The rise in the P/E multiple, meanwhile, is largely a consequence of the sharp fall in the equity risk premium  (the expected future return of stocks minus the risk-free rate), partially offset by the rise in normalized real interest rates, the analysts write. A falling equity-risk premium is bullish for stocks as it indicates investors are demanding less return to hold equities over the perceived risk-free alternative (such as long-term government bonds).

Expectations the equity-risk premium will continue to fall from historically high levels has been the central feature of the bullish case advocated by a number of high-profile bulls. Indeed, hedge-fund titan David Tepper of Appaloosa Management jolted markets higher in mid-May when he emphasized his ERP-based bullish call in an appearance on CNBC .

Its also a big part of BofA Merrills call. The analysts said their new target is driven in large part by their fair value model. in which they lowered their year-end ERP forecast from 600 basis points to 475 basis points, partly offset by a 50 basis point rise in the risk-free rate. Given that the premium is still elevated compared to pre-crisis levels below 400 basis points, a further decline in the premium and rising real rates could both provide a tailwind for equity investors over the next several years, they contend.

William L. Watts

Follow William on Twitter @wlwatts