With the exception of an August melt-down, this year has so far been remarkably similar to both 2010 and 2011. Starting out strong, the market encountered some fresh volatility in April before a steep, but controlled sell-off in May.
As we've all seen, that original sell-off now appears to have been overdone. The S&P 500 (SPY) looks to be making a run at the 52 week high of 1,422, which would have it trading at 13.7 times consensus estimates for $104 in cumulative operating earnings.
Speaking of earnings, it's important to take a look at the current estimates for FY 2012 operating EPS for the S&P, in addition to trailing earnings and the possible price targets based on a variety of valuations.
In order to arrive at a reasonable prediction for the value of the S&P at year end 2012, we'll need an estimate of the cumulative earnings per share on the index.
Operating earnings for FY 2012 are currently forecast (pdf) to be about $104. Built into that model is essentially flat year-over-year 2Q and 3Q EPS growth, and then huge 4th quarter of 16%.
Even more optimistic is the estimates for some individual sectors. Materials companies, for example, are expected to enjoy EPS growth of almost 100% in 4Q, while industrials are supposed to see growth of almost 20%. While plausible, earnings estimates are far more likely to surprise to the downside.
Given the slowing global growth story, double digit 4th quarter EPS growth seems highly unlikely. In 2Q, we saw flat to slightly positive EPS growth (if you include the financials), in conjunction with a 1.5% US GDP print. After adding 3 basis points to 2Q GDP, declines in consumer and business confidence appear to be resulting in flat inventories. JP Morgan expects 3Q of 1.5% and 4Q GDP of 2.5%.
In Europe, the second quarter was characterized by a deepening recession in the periphery, and flat growth in the core countries of Germany and France. This trend has continued into the third quarter, and recent data showed that while France and Germany just barely escaped a quarterly contraction, the EU is now officially in a recession with -0.2% GDP growth. France and Germany are only a few basis points from joining the recessionary party.
The Chinese economy showed the world that it is not impervious to negative external forces, as GDP came in at 7.6% (a three-year low) and the manufacturing PMI remained in a contractionary state. Recent data show continued weakness in manufacturing.
Given these facts, and the knowledge that sub 2% GDP growth generally coincides with flat EPS growth, $104 in cumulative operating earnings is a best case scenario. The first half of 2012, which included a strong Q1 thanks to abnormally warm weather, has brought about $50 in EPS; the second half should achieve similar, if not slightly lower results for FY 2012 EPS of $100.
Based on $100 in earnings, here are some potential end of year values:
13X earnings: 1,300
Of note is that the S&P is currently trading at a little over 16 times trailing earnings (operating EPS of about $87). This is just about in-line with the historical TTM P/E of 15.5.
Built into market expectations is $110 in forward (12 month) earnings, and FY 2013 earnings of $118. Assuming 2012 EPS of $100, 18% annual EPS growth would be exceptionally surprising in a deleveraging, slowing global economy where corporate profit margin expansion has slowed significantly (and even begun to decline).
Predicting what investors are going to be willing to pay for a dollar of earnings at the end of 2012 is a difficult task, but we can probably generate some sort of range.
On the lower end, 13.5X earnings seems reasonable. At this past June's market lows, in the midst of legitimate Greek-exit concerns, the Spanish bank bailout, distressed sovereign debt, and US recession fears, investors were valuing the S&P 500 at about 14.7 times trailing earnings.
If the end of 2012 brings us a sovereign bailout, a Greek exit, or the like, it's unlikely that the trailing multiple would fall below 13.5, given what we saw this past June.
On the upper end, I can't imagine a year-end P/E greater than 15. With hefty forward earnings estimates already built into current valuations, and catastrophic risks still abundant, 15X wouldn't make much sense from a logical standpoint. Assuming a value of 1,500, the S&P would be trading at 13.6 times lofty forward estimates of $110, which is above the historical forward P/E of about 12.8. Far more likely is that earnings estimates are gradually brought down to $103-$105, implying 3-5% 1H 2013 EPS growth.
Keep in mind that while investors are fine with paying 16 times earnings today, the VIX reached a 5 year low this week under 13.70, and the combination of QE hopes and speculation regarding sovereign bond purchases are adding to the "risk-on" environment.
What we're left with is a 2012 S&P target range of 1,350 to 1,500. While this is a fairly wide prediction, I think the exercise is a good tool for investors and traders when positioning their investments, and puts market headlines and action into perspective. My personal target is at the lower end of that range, closer to 1,400.
Investors expecting a market melt-down are likely to be very disappointed given the earnings picture, while uber-bulls expecting double digit year-end returns will probably be proven overly-optimistic.
Some might argue that stocks deserve a premium valuation relative to historical standards, due to exceptionally low interest rates. I don't think this is fair conclusion. Central bank promises to keep interest rates exceptionally low until 2014 signals to the market that bond prices won't ever really be able to fall very far. As a result, its difficult to get bond holders into equities.
Furthermore, given the structural issues in both European sovereigns and the euro currency itself, corporations, pension funds, and the like strongly desire the guarantee of capital return that bonds imply. The "money on the sidelines" fallacy, or hopes that bond holders will "pour into equities" ignores the psychology behind the current dynamics of capital flows.