With the bulls seemingly in control for now, I figured taking a rational look at both the bull and bear camps would be a useful exercise in clarifying the medium-term (six months to one year) market outlook.
When it comes down to it, the only thing that really matters is earnings. In the short term, we can talk about risk repricing as a result of volatility measures and the like, but over any meaningful investment horizon, stock prices do in fact follow earnings and cash flows. Therefore, any factor we consider for either the bull or the bear case has to have some ultimate effect on earnings.
For example, saying "I think QE3 is on the way" isn't nearly enough. Whether the bears want to admit it or not (and I was one of the ones who didn't), the first two rounds of genuine QE didn't just inflate stock prices -- they widened margins, lowered borrowing costs, and resulted in record EPS for U.S. corporations. If all QE did was "inflate stocks," we'd be looking at a severely overvalued S&P 500. The reality, however, is that at about 16 times earnings, equity values appear to have followed the improvement in earnings at a reasonable pace.
What we have to consider is whether QE3 would have a legitimate effect on earnings; "risk on" has nothing to do with it. In order to have the desired effect on earnings, borrowing costs for companies have to once again drop meaningfully, and consumer spending needs to pick up as a result of either the textbook "wealth effect" or because even lower interest rates make the consumption of wealth a more rational choice than saving it.
That said, I'll start with the bull case, meaning reasonably higher stock prices over the medium term:
- Forward (12-month) estimates call for $110 in EPS. At this level of earnings, the market would be trading at less than 13 times trailing earnings, a 16% discount to the historical ratio.
- Europe has been able to buy time without implementing any sort of open market operations. LTRO and sovereign bond purchases are still on the table. LTRO would result in a renewal of the carry-trade, whereby European financials purchase high-yielding, risky sovereign debt and theoretically make money on the huge spread. By reducing sovereign yields and loading the banks up with free assets, EU lending and business conditions should theoretically improve, an obvious plus for one of its biggest trading partners, the U.S. Companies like Dow Chemical (DOW) do about 50% of their business in the EU.
- QE3 is on the table. Bulls hoping for imminent QE are definitely going to be disappointed, given high oil and grains prices and stocks priced near their highs. The Fed typically hasn't stepped in until 15%-20% declines in equities and WTI oil under $80 per barrel. Most market participants don't seem to genuinely believe that QE is coming soon, but that it will be rapidly implemented if the market drops. As for earnings, and ultimately stock prices, the effect is likely to be muted for reasons explained in the bear case.
- Housing appears to remain in a bottoming process. Though not in a "recovery," home prices are no longer falling precipitously and are actually rising in most cases. Housing starts remain muted, however, and this should persist for some time given the extent of the shadow inventory. Rising home prices, especially in states like Nevada where people have been underwater on their mortgages, could be a boon for many regions as people are granted some flexibility and can move to new jobs. Additionally, higher home prices create an obvious wealth effect, leading to greater consumer spending and higher corporate earnings. At the very least, housing is no longer a "minus" on U.S. GDP.
And now for the bear case:
- Forward estimates calling for $104 in cumulative S&P earnings for FY 2012, $110 in forward earnings, and almost $118 in FY 2013 earnings appear too optimistic and are predicated on a dramatic decoupling of the U.S. from the rest of the world. The fourth quarter of 2012 alone is supposed to enjoy 16% EPS growth. There is a far greater likelihood of earnings disappointing to the downside over the next 12 months than earnings meeting, let alone beating, expectations. Given the fact that current valuations are based on the expectations for future (very optimistic) earnings, a decline in realized earnings will result in lower price to earnings multiples and lower stock values.
- While the EU has indeed been able to buy time without any recent open market operations, the effect on its real economy has been nil. The eurozone is now officially contracting at a rate of 0.20% annually, and the core (Germany and France) are just barely clinging to their growth stories. With EU unemployment at record highs and EU PMIs in conditions of moderate to severe contractions, tax revenues are likely to decline in states already running huge deficits. Given the fact that no structural improvements have been made on the budgets front, it's only a matter of time before the next leg of the euro crisis takes hold. It's important to note that the ultimate effect of the "crisis" is unlikely to be catastrophic, as a great deal of the risk has been offloaded by the private sector. Sovereign yields are also still painful, with the Spanish 10-year yield at 6.50%.
- With the VIX term structure hovering at five-year lows, equities seem to be implying that risk has been largely vacuumed out of the system. Let's not forget we felt eerily similar in the first three months of 2012, when such perceptions led to the JPMorgan trading blowup. While the VIX by no means "must" rise (and equities consequently fall), the historically low reading indicates limited upside to the expansion of market multiples. With earnings forecasts unlikely to rise from their already elevated levels, stock values will probably be trading in a sideways, slightly negative fashion.
- Jobless claims remain elevated above 360,000, and without a new economic catalyst like QE coming into play, will probably remain at such levels until our deleveraging cycle is completed (not for several years).
- Given continued deterioration in Europe and declining growth in China and the rest of the BRICs, U.S. GDP is likely to remain around 1%-1.5% over the next 12 months. As we saw in the second quarter, 1.5% GDP growth coincides with flat corporate earnings.
- While the fiscal cliff will likely turn out to be overblown, some concessions may have to be made on both sides, resulting in higher taxes in some areas of the economy or lower spending. Any contractionary move in fiscal policy will pressure record corporate profit margins, since government has been the main driver of investment.
Although the next 12 months will likely prove as volatile as the last 12, I think equities will largely remain within 10% of current levels either way. On the upside, 1,550 by this time next year would imply a market multiple of a little less than 15, assuming earnings estimates come to fruition. I don't think they will; $100 in operating earnings seems far more reasonable.
There's not a ton of downside either, unless earnings reverse course as a result of an unforeseen recession. The June 2012 lows of 1,280 had the market trading at 14 times trailing earnings, and 12.8 times my forecast ($100) for forward 12 months' earnings -- in line with historical forward multiples.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.