This commentary originally appeared on
on Oct. 3 at 8:38 a.m. EDT.
This week, I will ask 10 questions to both the bulls and the bears, the answers to which will help us determine the outlook for equities over the balance of the year and into 2012.
Today I will start by asking 10 questions to be addressed to bullish investors. (Later in the week, I will get to the bears.)
Pace of domestic economic growth: As visibility has been reduced, do you still believe that domestic recovery growth will be moderate and will not double dip? As I have previously noted, do the rather obvious and ominous deflationary signals (e.g., lower real incomes in Friday's report, plunging commodities and the technical breakdown of the market, in general, and industrial and transportation equities, in particular) suggest a more adverse and different economic outcome to the bullish consensus? Or are the latter two factors, in particular, laying the groundwork for more positive ingredients and reagents to economic and profit growth (e.g., lower commodities seen as a "tax cut" and a positive for corporate margins) and more attractive equity entry points?
The U.S. economic recovery: Do you still hold to the view that the domestic recovery will be continuous, smooth, self-sustaining and will average something close to the duration of previous cycles (44 months) and not double dip?
Europe: While Europe remains a wild card, given the disparate interests and a seeming lack of urgency, how can we be confident that a resolution will take place that does anything more than paper over the problem?
Washington, D.C.: We are moving ever closer to the November 2012 elections. Is it reasonable, under these circumstances, to expect decisive, pro-growth fiscal initiatives in a divided political arena characterized by the normal vitriol that takes place during and leading up to the Presidential contest?
Appropriate net invested percentage: Given some pressure on economic/corporate profit forecasts, is the reward relative to risk attractive now? And what is a suitable invested position (net long) given the wide number of outcomes that seem possible?
Earnings warnings: In light of the Ingersoll-Rand profit warning on Friday (an industrial company serving a broad customer base) and many other more sluggish economic indicators, what do you think is a realistic S&P 500 profit forecast for 2012? How does that projection compare to the consensus projections?
Timing of reallocation trade: Retail and institutional investors have abandoned the equity market. At what point and what are the specific catalysts for institutional pension plans to make a meaningful move out of fixed income into stocks?
Validity of valuation models: With interest rates artificially low (in zero-interest-rate Fed policy), are most, if not all, valuation models based on rates (Fed model, dividend discount model, risk premiums) not predictive or losing their relevance as interest rates are managed now and there is an inevitability that when zero-interest-rate policy comes off, rates will shoot higher?
Volatility: High-frequency-trading strategies and intra- and end-of-day re-weightings of leveraged ETFs have created a volatile and unpredictable market backdrop in which institutional and retail investors are abandoning the market. With this uncertain market backdrop, why should one expect investors to re-risk and/or return to equities anytime soon? (Separately, to what degree will the recent drop in stock prices impact the real economy?)
S&P 500 target: About three weeks ago, I did a probability distribution based on four economic/market scenarios that produced an S&P 500 objective of about 1205. (See my assumptions in steps one and two in the text below.) Last week, Morgan Stanley's strategy team made a similar presentation. Here is a comparison of both our outputs. If your S&P target is higher, which assumptions do you disagree with?
My methodology, assumptions and probability distributions from a
produce an S&P 500 target of about 1205, about 5% above current levels:
Scenario No. 1 (probability 15%): The pace of U.S. economic recovery reaccelerates to above-consensus forecasts based on pro-growth fiscal policies geared toward generating job growth), still low inflation, subdued interest rates and the adoption of aggressive plans by the government to deplete the excess inventory of unsold homes. Corporate profits meet consensus for 2011, and 2012 earnings estimates are raised (modestly). Europe stabilizes, and China has a soft landing. Stocks have 25% to 30% upside over the next 12 months. S&P target is 1500.Scenario No. 2 (probability 15%): The U.S. enters a deep recession precipitated by a more pronounced negative feedback loop, a series of European bank failures and likely sovereign debt defaults in the eurozone. While 2011 corporate profits and margins disappoint somewhat (we are already well into full-year results), 2012 earnings estimates are materially slashed. China has a hard landing. Stocks have a 20% to 30% downside risk over the next 12 months. S&P target is 885.Scenario No. 3 (probability 30%): The U.S. and Europe economies experience a shallow recession. Earnings for 2011 are slightly below expectations, but 2012 corporate profits are cut back to slightly below this year's levels. Stocks have 10% to 15% downside risk over the next 12 months. S&P target is 1030.Scenario No. 4 (probability 40%): The U.S. and European economies "muddle through" in a modest expansion mode (hat tip for the term to John Mauldin). Profits for 2011 meet consensus expectations, but slippage in margins brings down 2012 corporate profit growth projections somewhat. Stocks have 10% to 20% upside over the next 12 months. S&P target is 1355.
Again, my exercise produces a mathematical solution, based on the above scenarios, of a (melded) S&P 500 price target of about 1205, about 5% above the current cash index.
Morgan Stanley Methodology
For a full explanation of Morgan Stanley's comparative methodology and assumptions, which produce an S&P 500 target of 1135 (flat with the current cash index), please go to Morgan Stanley's September 25, 2011 Investment Strategy piece.
Doug Kass writes daily for
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At the time of publication, Kass and/or his funds were long MS, 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.