Scenario No. 3 (probability 25%): The U.S. experiences a disappointing sub-1% real GDP growth rate, and Europe experiences a medium-scale recession. S&P 500 profit forecasts for 2012 are cut back to $98 to $100 a share (only slightly above 2011's levels). Stocks, valued at 12x under this outcome, have 12% downside risk over the next 12 months. S&P target is 1185.
Scenario No. 4 (probability 45%): The U.S. muddles through with 1.5%-2.0% real GDP growth, and the European economies suffer a modest (but contained) business downturn. S&P 500 profits for 2012 trend toward a range of $103-$105 a share as some margin slippage occurs. Stocks, valued at 13.25x under this outcome, have 2% upside over the next 12 months. S&P 500 target is 1,375.
To conclude, the S&P 500 closed at 1342 on Friday, almost exactly the level (1345) that I calculate as fair market value based on the four economic and stock market outcomes (and probabilities) listed above. Risk and reward, therefore, seems generally in balance.
The Ingredients for a New High in the S&P 500 in 2012Let's now shift our narrative from the near term to the intermediate term, for it is the intermediate term that excites me as an investor. In order for the markets to approach all-time highs in 2012, which I continue to view as possible, much must go right. My ambitious 1550 target for the S&P 500 (first offered in December 2011) seems less of an outlier today than two months ago. It would require the revival of animal spirits driving valuations back to average historical levels, which would be a difficult but not impossible feat given economic, geopolitical and political uncertainties and within the context of the headwinds of our country's fiscal imbalances. Below are 10 important factors that I am monitoring -- with current trends in parentheses; four are moving positively, and six are moving negatively -- that could catapult the market this year to much higher levels.
- An improving U.S. economy (+): Economic statistics (PMIs, ISMs, leading indicators, housing and jobs) must continue to be on the mend.
- A soft landing in India and China (-): Growth is moderating while inflation is accelerating.
- Broad-based technical strength (-): The market's breadth has started to narrow (often a sign of a potential top), as a few high-profile stocks seem to be responsible for most of the recent advance Indeed, one might describe this as "the NBA market," as in "nothing but apple."
- Reduced volatility (-): Market volatility must continue to subside. It has trended lower throughout January but has recently started to rise.
- Political compromise in the U.S. (-): Our political leaders must become less divisive and less divided. Unfortunately, as we move closer to the November elections, compromise (leading to pro-growth fiscal initiatives) seems a more distant possibility.
- Global monetary ease (+): We remain comfortable that central bankers around the world will continue to keep interest rates low.
- Containment of the eurozone debt crisis (+): Europe's central bankers and leaders must continue to implement policy that contains the debt contagion (as they have in recent months).
- Reduced geopolitical risk (-): If anything, the tension between Israel and Iran has intensified.
- Prospects for a Republican presidency (-): Politics aside, history shows and most investors today view a Republican victory as business- and market- friendly. However, recent Romney caucus and primary losses have improved the chances of the Democratic Party recapturing the presidency. (The Intrade.com probabilities have declined for Romney to win the nomination from almost 90% to under 80% and have been lifted for Obama to win the presidency from the low 50%s to nearly 60% now.)
- Improving fund flows (+): The multiyear trend in which individual investors and hedge funds retreat from U.S. equities must be reversed. Retail investors have begun to commit money into domestic equity funds over the last three weeks and ISI's hedge fund survey indicated a sharp increase in net long exposure last week.