2011 has looked a lot like a roller coaster to investors, but the market is likely about to look like a rocket going forward. After 5 straight monthly declines, the market has recovered 73% of the losses from the 5/2 high of 1370 to the 10/4 low of 1075. All of this in just 19 trading sessions!
The market is the Great Humiliator. Those who weren't flexible were likely looking foolish at some point over the past few months. Declines and subsequent rallies like we have just experienced are few and far between. It is rare the investor who was able to get out but also get back in (not me!). More common, unfortunately, is the investor who threw in the towel when things got rough and is now wondering what to do (not me!).
Sticking to the thrill-ride theme, we did a bungee jump at the end of July. Unfortunately, we didn't know that at the time! Actually, I would characterize it as a helicopter bungee jump, and who knew if Helicopter Ben would (or even could) keep control:
Bungee jumping is really a pretty good analogy, as the July 29th close of 1292 was where the bounce-back on Thursday stopped roughly. So, what now?
A little over a year ago, I laid out the case for 1500 by the end of 2011. I was foolish enough to affirm it in July, feeling pretty good about that call until the bungee jump. During the downturn, I laid out some scenarios suggesting that the year could end strongly, most recently discussing the Hail Mary potential in mid-September. At this point, 1500 seems unlikely, as it would require an almost 17% rally. I'll settle for 1400!
Trying to predict what will happen over a very short time-frame is never easy, and I am actually more comfortable thinking a year or so out. Absent some freakish miracle, my very bullish call for 2011 will miss the mark, but will likely prove directionally correct. Before I describe why I think we will make all-time highs for the S&P 500 in 2012, let me review my previous thinking.
A year ago, I suggested that the expected 2012 S&P 500 earnings at year-end 2011 would likely be close to $100, which was a little below the current consensus at the time. I projected that due to low interest rates and decreasing investor risk-aversion as we moved further away from 2008 the forward multiple would expand from about 13 to 15. Hence, 1500 (15 x 100).
What actually happened? The current consensus for 2012 is actually higher, now approximately $108 according to Standard & Poors. Closing near 1285, the 2012 PE is actually currently below the 2011 PE a year ago at 12X. So, based on earnings, the market cheapened despite even lower corporate bond yields.
In setting my 1600 target for year-end 2012, I am assuming that the earnings for 2013 will be $115, which is about 8% compound growth from 2011 projected earnings of $97.65. I am going to lower my projected market multiple to 14, which seems too low, but it will allow for a pretty big hike in interest rates that I expect to see as the year progresses. The actual result of that math is 1610.
Clearly we didn't get the multiple expansion I expected this year, so how can I continue to project PE expansion? According to Baseline, the trailing PE for the past 25 years has been between 10 and 30, with a median of 17. Removing the bubble valuations, the trailing PE has been more typically between 15 and 21. If I adjust for forward rather than trailing by assuming a 10% lower number, a typical forward range is 13.5 to 19. So, 14X is a very modest assumption, especially in light of the lack of competition from corporate bonds or other asset classes. Flip the current forward PE of 12X and you get an earnings yield in excess of 8%. This is quite generous compared to what's available in long-dated corporate bonds (less than 5%).
My view is that it is taking longer to get the "fair-value" PE than I had expected due to lingering fears following the twice-in-a-century type of market we went through in the Great Recession. Quite simply, stocks have to be a good bargain for a long time before they will get respect or even love.
Even most bears will admit that valuation is at least fair if not cheap. But cheap clearly isn't enough. We need to have stable to improving fundamentals. Here, I think that most of us are being lulled into a state of pessimism that is unwarranted but not surprising. Sure, fiscal debt, high unemployment, a decimated housing industry and strained consumer balance sheets are lingering, but none of this is getting worse. Rather, it's taking frustratingly long to improve, making it easy to extrapolate that it will never get better. I continue to believe that the economy will be OK, not great.
I can't prove that the economy will get back above "stall speed", but if I were negative I would be scratching my head. The 3rd quarter included two months of plunging Consumer Confidence, yet GDP expanded! Most folks focus on Real GDP, which adjusts for inflation, as opposed to Nominal GDP, which is the measure expressed in "today" dollars. Nominal GDP is more meaningful to me as a stock analyst. Why? Stock prices are nominal prices as are the underlying earnings. The 5% annualized quarterly Nominal GDP was the best since H1-2010 and Q4-09. The actual year-over-year growth was 4%, but it's accelerating nicely now.
One of the big positive fundamentals over the past few years has been emerging markets' economic growth. With recent monetary policies switching from tightening to easing in several of these countries, it's likely that they will sustain still robust economic growth, which will help our exporters. Western Europe, which should have been easing rather than tightening this year, is likely to reverse course, hopefully staving off recession there. The PMI export component actually accelerated from 50.5 to 53.5 a month ago and has remained robust despite the turbulence.
The US Consumer feeds the vast majority of our economic growth, and the outlook here seems ok to me. Exports and Capital Investment both also should see some growth. What about government spending? State and locals are enjoying rising sales tax receipts and seem to have improved their financial position, but clearly federal spending will be a drag. Still, adjusting for this headwind, it's likely that we should grow nominal GDP near 5% which can fuel the 8% EPS growth in the S&P 500.
While the valuation argument seems compelling and the fundamentals at least ok, what do the technicals say? From my vantage, as bad as this market was, we held the trading range at the bottom of the 2010 correction. Here's a weekly chart of the S&P 500 over the past 5 years. Click to enlarge:
This is a very good chart, not yet great. It will be great when we clear the 1350 area. What makes it good? As I mentioned, we held the support levels from 2010, with 1120 holding on a weekly basis. Note also that the market cleared 1270 this week, which should have contained the rally, as it was the bottom of the consolidation earlier this year. This was also where the market broke down in June of 2008. In my view, we are set up to do work now in the 1350-1600 area once we get through 1350. The MACD chart supports a bullish view, and the markets have regained their 200dma. Finally, other measures suggest we are only modestly overbought in the short-term.
Financials look to be participating, which encourages me regarding the overall outlook. A look at the NASDAQ 100 also confirms reason for optimism, as it closed just under it's highest levels since the 2000 bubble.
Tying it all together, I am sure many think we are still on the roller coaster that has exemplified the "lost decade" of investing, but I believe that the recent correction, which is clearly over, has cleared the decks. It looks like the rocket has launched.
I have laid out my thinking for why I believe a year from now we will be talking about the likelihood of all-time highs. Valuations are still quite low, the fundamentals, while mixed, are conducive to moderate EPS growth and the technicals have improved greatly.
In the coming weeks, I expect, just as I suggested last year, pension funds will be rebalancing towards equities. The low interest rate environment magnifies the size of liabilities and minimizes the appeal of investing in fixed-income. Quite simply, stocks are the best game in town.
We have a near-term event-risk in the Super Committee next month. I think we could be pleasantly surprised as the bar is very low. If the European deal last week can be accepted as progress, it won't take too much given how low expectations are here. I am hearing talk of a plan that goes way beyond the minimum. Once we get that out of the way, Joe Investor, who has been whip-sawed silly, will likely jump on too.
I know that this is an optimistic outlook, but I won't apologize. I am not a perma-bull - four years ago I was posting about building an ark for the coming flood. Stocks are cheap, the economy is OK, and we now have the technical winds at our back.