This column originally appeared on Real Money Pro at 8:45 a.m. EDT on May 29.
NEW YORK (
"The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell." -- Sir John Templeton
- I have slightly adjusted my S&P 500 fair market value downward from 1485 to 1455, but the market is still about 10% undervalued.
- A trading range of 1290 to 1455 seems probable for the balance of 2012.
- Reward vs. risk is favorable, with 4.5x more upside than downside.
- The world's stock markets are hostages to Greece, but I expect Merkel & Co. to step up.
- Successfully containing the eurozone debt crisis (or even evidence that the Greek Democratic Party will forge an election victory) will likely result in a spirited market rally.
Last month, I
my four 2012 scenarios with new 2013 economic, corporate profit and stock market outcomes -- it produced a S&P 500 fair market value calculation of 1485.
Let's investigate what fundamental, sentiment and valuation changes have occurred since my last fair market value was updated four weeks ago.
U.S. Economy: A Mixed Bag. Domestic economic data have been mixed relative to my expectations. First-quarter 2012 real GDP growth likely came in a tad under 2%, and second-quarter 2012 real GDP growth should be in the 2% to 2.5% range. Nevertheless, we still seem destined to muddle through with 2% real GDP growth in 2012-2013. Payrolls growth seems stuck at a slightly below consensus level, and the rate of growth in manufacturing activity is decelerating modestly. On the other hand, some major positives for global growth include the drubbing in commodities (a tax cut to the consumer and a prop to corporate profit margins, which opens the door for more stimulative monetary policy around the world), the improvement in housing (the sector represents the greatest divergence in economic series relative to consensus) and still-healthy/elevated consumer sentiment.
Europe's Economy: On the Precipice? The continued debt crisis has resulted in much more risk to economic growth in the eurozone. Greece is moving toward a depression, Spanish yields have recently spiked, and even Germany's manufacturing PMI is falling (to 45.0). While I had expected Greece to exit the eurozone in 2013, there is now a distinct possibility that the nation's exit is imminent (particularly after its elections two weeks ago). The new Greek elections in mid-June will be telling as to what the future holds -- yesterday an opinion poll suggested the possibility of a win for the pro-bailout parties, which could ease concerns that Greece will exit the currency bloc. For now, the U.S. stock market seems hostage to European developments. Many, including Harvard's Niall "We Are About to Start the Second Half of Our Great Depression" Ferguson, are concerned that a European Lehman moment is at hand, but I continue to expect that eurozone authorities will ultimately move to create an FDIC-like facility to insure European bank deposits and will seriously consider floating euro bonds.
China's Economy: Slowing but Not Yet a Hard Landing. A soft landing seems the base case scenario, but there are emerging question marks (e.g., seven months of lower PMIs and lower energy consumption statistics).
Corporate Profits: Still on Tap for $100-Plus S&P 500 EPS in 2012 and Further Growth Seen in 2013. Approximately one-sixth of aggregate S&P profits come from Europe, but most of our corporations' European sales/profits are derived from the strongest members of the eurozone. Over there, eurozone real GDP growth is likely to be down by less than 0.5% in the first half of 2012; the second half is problematic, and visibility is weak into 2013. The U.S. remains the best house in a bad neighborhood -- with 2% real GDP growth and 2% inflation, nominal GDP growth is likely to be over 4% this year, translating to 5% to 7% sales and profit growth.
Investor Sentiment and Expectations: Low. The known negatives seem increasingly discounted: a month of near-double-digit market losses, a flopped Facebook IPO, the disclosure of a large derivative loss at JPMorgan Chase and a possible Greek exit from the eurozone. Contrarian alert: The domestic equity fund outflows in the first half of the month of May were more than 4.5x the average over the first five months of the year (which was a record) and even greater than the first five months of 2008-2009! Financial Times featured a cover story on "the death of equities," which is another sign that we are at a negative sentiment extreme. Meanwhile, trading volume is evaporating, down 7% last week (over the prior week), down 30% year over year and down 40% below its peak in 2010. Frankly, if someone had told me year ago that the U.S. would be growing at a 2% real GDP rate, with a 1.75% 10-year U.S. Treasury yield, I would probably have projected a market P/E closer to 16x-17x vs. to the current 13x. Stated simply, stocks have become an unpopular asset class.
Today I have updated the probabilities of the four outcomes to reflect the five changing conditions above. In large measure, the worsening situation in Europe is leading me to reduce my calculation of the S&P 500's fair market value from 1485 to 1455, which is still more than 10% above the cash level at last Friday's close of trading (1317). Here are the changes to the four outcomes:
- I am decreasing the probability of an above-consensus reacceleration in domestic economic activity (defined as 3% or more 2013 real GDP growth) from 15% to 5%.
- I am leaving unchanged the chance of a U.S. recession in 2013 at 5%.
- I am increasing the probability of sub-1.5% 2013 real GDP growth from 20% to 25%.
- I am increasing the likelihood of my baseline, muddle-through scenario (defined as 2013 real GDP growth of between 1.5% and 2.0%) from 60% to 65%.
My base case of muddling through, with a better than six in 10 probability, yields an S&P 500 price target of 1540, far higher than my fair market value calculation of 1455. Below-consensus growth (scenarios No. 2 and No. 3 below), which is accorded less than a one-third probability (the second-highest probability), yields an S&P 500 target of 1290, slightly below both the current level of S&P 500 cash (1317) and well under my 1455 fair market value estimate.
Given the proximity to 1290, an overshoot to the downside is clearly possible, particularly if Greece exits the eurozone in a non-orderly fashion. But, in all likelihood, I expect the S&P 500 to be contained within the range of 1290 and my fair market value of 1455 over the balance of the year. Taken literally, this would mean that there are about 30 S&P points of risk and 138 S&P points of potential reward, for 4.5x more reward vs. risk, which provides an attractive market entry point today. It may be time to take a bullish and contrarian investment stance.
As I have repeatedly written, my methodology, though appearing precise, recognizes the difficulty of attaining investment precision given the numerous moving parts (economic, interest rates, sentiment/psychology and exogenous factors) in its calculation. It is intended more as a thoughtful guideline (of reasonable expectations/outcomes) than an exercise that should be taken literally. (Input your own probabilities and outcomes to produce your own market expectations).
Below is the criteria and methodology I use to evaluate the S&P 500 and upon which I conclude that fair market value is approximately 1455, or about 10% above Friday's closing S&P of 1317.
Scenario No. 1 -- Economic Reacceleration Above Consensus
(probability goes from 15% to 5%): The pace of U.S. economic recovery reaccelerates to above-consensus forecasts (3%+ real GDP growth) based on pro-growth fiscal policies geared toward generating job growth; corporate profit margins being preserved (with low inflation and contained wage growth); interest rates remaining low; and durable spending (housing and autos) recovering sharply as pent-up demand is unleashed. The $550 billion fiscal cliff is whittled down to only about $150 billion (subtracting less than 0.5% from 2013 peal GDP) as President Obama (the incumbent wins) and a Republican Congress learn to compromise on taxes, entitlements and deficits. Europe stabilizes (and experiences a shallow recession), and China has a soft landing (with GDP growth tracking in excess of 8%). There is no QE3. S&P 500 profit estimates for 2013 are raised to $110-$113 per share. Stocks, valued at 15.5x under this outcome, have 23% upside over the next nine months. S&P target is 1725.
Scenario No. 2 -- Recession
(probability stays at 5%): The U.S. enters a recession precipitated by a loss of business and consumer confidence, producing a fall in manufacturing output and personal consumption expenditures. The Democratic Party regains the White House and the Senate, but the Republicans maintain control of the House of Representative. The schism between the two parties persists. Partisanship leads to rancor during summer debt-ceiling deliberations (instituted because of slowing nominal GDP) similar to that of August 2011. Confidence deteriorates further and the housing market seizes up as bank lending becomes more restrictive when the fiscal cliff is not remedied/addressed (the hit to GDP is -1.5% to -2.0%). QE3 is instituted but fails to contain the economic weakness. A series of European bank failures and EU sovereign debt defaults contribute to a deepening European recession and a hard landing in China and India. S&P 500 earnings estimates for 2013 are materially reduced to $75 to $80 per share. Stocks, valued at 11.5x under this outcome, have 36% downside risk over the next nine months. S&P target is 890.
Scenario No. 3 -- Below-Consensus Economic Growth
(probability goes from 20% to 25%): The U.S. experiences a disappointing sub-1.5% real GDP growth rate, Europe experiences a medium-scale recession, and China's economic growth disappoints modestly relative to expectations. QE3 is initiated and has a modestly favorable impact on aggregate growth. Obama regains the presidency, and the Republicans control Congress. The fiscal cliff is reduced by less than half (to $275 billion-$350 billion). The S&P 500 profit forecasts for 2013 are reduced to levels slightly below 2012's results as corporations' pricing power is limited and profit margins are pressured, so S&P profit forecasts are cut back to below consensus of $98 to $100 per share. Stocks, valued at 13.0x under this outcome, have 8% downside risk over the next nine months. S&P target is 1290.
Scenario No. 4 -- Muddle Through
(probability goes from 60% to 65%): The U.S. muddles through, with 1.5%-2.25% real GDP growth, and the European economies suffer a modest (but contained) business downturn. China's and India's economies grow in line relative to consensus forecasts. There is no further quantitative easing. Obama regains the White House, and the Republicans control Congress. The fiscal cliff is reduced by half (to $275 billion). S&P 500 profits for 2013 trend toward a range of $107-$109 per share as some modest margin slippage occurs (coincident with escalating inflationary pressures). Stocks, valued at 14.25x under this outcome, have 10% upside over the next nine months. S&P target is 1540.
At the time of publication, Kass and/or his funds were long JPM common/short JPM calls, although holdings can change at any time.
Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.