2012 is off to a fabulous start, with the rare event of no one being able to buy at last year's prices so far. As you can see, the year is actually tracking our fast start in 2011:
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I am not expecting the same time of action that we saw in each of the past two years, when the market peaked at the end of April and weakened during the summer. In fact, as I shared in late October, I expect that the S&P 500 will move to an all-time high this year, specifically forecasting 1600.
While 1600 may sound incredibly unrealistic to some, it would represent a one-year return of 27.6%. Of course, that's a two-year return of 27.6% as well. Perhaps an even better way of looking at it is that it would represent a five-year return of 9% - not exactly a barn-burner, especially in light of the fact that earnings for the S&P 500 are projected (at $105) to be 17% or so higher than in 2007.
Quickly reviewing "The case for 1600", I had mentioned that the forecast was predicated on modest earnings growth with some multiple expansion. Specifically, I am expecting that the market multiple will move to 14 on projected year-end 2013 earnings of 115 (actually 1610).
I also cited improving technicals at the time, which continues to be the case. The recent run in Small-Caps is an early harbinger that the retail investor may be re-entering the market after years of absence. For those who don't recall, Small-Caps diverged horribly last year, actually declining in January as the rest of the market got off to a great start. I had discussed my expectations that the 2012 experience would differ in when I predicted that Small-Caps would Outperform in January for the first time since 2006. Indeed they did, with the Russell 2000 (IWM) returning over 7% compared to the 4.5% return for the S&P 500 (SPY). As of February 17, the advantage has widened to 3.4%.
While many think that the market doesn't look healthy due to a misconception of narrow leadership, this isn't the case at all. A few days ago I dispelled this myth of narrow leadership. Even in some of the weaker sectors so far in 2012, the breadth is excellent.
While the closing high of the S&P 500 on Friday was the highest since the market bottomed in 2009, many parts of the market had already blown through the levels at the prior highs last April. While certain parts of the market are still well below their values last April (Financials, Materials, Energy), others are well beyond (Technology, Consumer Discretionary, Utilities, Staples). Here is the complete list of price returns by sector since the end of April:
- Technology: +7%
- Consumer Discretionary: +6%
- Utilities: +6%
- Consumer Staples: +5%
- Health: +3%
- Industrials: -3%
- Energy: -7%
- Telecom Services: -8%
- Materials: -9%
- Financials: -10%
I am encouraged by the recent strong moves in Tech and Consumer Discretionary, both of which have cleared their October highs too, but it's the action of the laggards that encourages me the most: All 5 sectors that are below their levels from last April are above their October highs.
A final technical indicator that signals better times ahead for equities is the performance of international stocks this year. In case you haven't been paying attention, Emerging Markets (VWO) / (EEM) are flying. Europe, the genesis of global contagion fears, is doing fine. In fact, during all the consternation this fall (as we were making new lows in early October), the bourses didn't brush their summer lows. Now, they are off to the races. Not to mention the debt of the PIIGS.
Let me tell you what really encourages me most: Early signs that the number one challenge the market has faced is ending. The headwinds of retail redemptions from stocks have been blowing furiously for five years now. Take a look:
According to the Investment Company Institute data, almost $500 billion has come out of domestic equity mutual funds. Now, I know retail chases performance, so the outflows from the second half of 2007 through early 2009 weren't surprising, but the divergence between market direction and retail participation since then has been stunning. In late 2009, they redeemed as the market recovery began. As soon as the market stalled in 2010 and in 2011, the redemptions kicked in again. It's no wonder that valuations are so puny these days!
Now, on the flip-side, look at where the money has been going:
Almost $900 billion has flowed into bond funds! It reminds me of the flows into stocks at the end of 1999. While it's way too early to call it a trend, recent data has shown an uptick in equity inflows. In the most recent week reported (2/8), flows were $1.8 billion, which was the best week in quite some time. Total equity inflows, including foreign, were $3.6 billion. They haven't released January yet, but here are the past several weeks for domestic equity:
- 1/4: -$6.9bln (bonds +$3.3bln)
- 1/11: +$736mm (bonds +$7.9bln)
- 1/18: -$801mm (bonds +$6.1bln)
- 1/25: +$850mm (bonds +7.7bln)
- 2/1: -$1.8bln (bonds +$7.5bln)
- 2/8: +$1.9bln (bonds +$7.1bln)
So, money is continuing to pour into bonds at a torrid pace, but, after an initial withdrawal, it looks like net flows have been slightly positive for domestic equities.
Bonds are at historically low prices, with investor hopes perhaps buoyed by Chairman Bernanke's irresponsible proclamation, in my view, that rates will remain low for the intermediate-term. There is an incredible amount of firepower ahead as investors rebalance. Sadly, it will take a torrid market to make this happen, but we are in a torrid market that I expect will force mutual fund investors to reverse their infatuation with an asset class that has limited upside, low base case returns and potentially lots of downside.
I had a bullish forecast in 2011 that didn't pan out, but it was predicated on modest economic growth that would result in expectations of $100 earnings for the S&P 500 for 2012, along with some multiple expansion. I got the earnings part and the growth part right, but multiples actually contracted as investors continued to shun stocks. For my forecast to work out this year, I believe that the retail investor must come back to stocks. We are already seeing signs in my view with the strong performance of Small-Cap. So, I am sticking with my 1600 forecast. We have good technicals, a low valuation still and improving fundamentals.