Trying to Hit a Moving Target

This commentary originally appeared on Real Money Pro on Aug. 29 at 7:56 a.m. EDT.

"It's tough to make predictions especially about the future."

-- Yogi Berra

Today, I want to outline my S&P 500 expectations for the next 12 months.

The purpose of presenting my approach to valuation is to offer a guide to readers of Real Money Pro about how to think about the relationship between the economy and Mr. Market, which, in the end, is the fundamental essence of forecasting.

Predicting the level of the S&P 500 one year out is particularly difficult these days in light of numerous uncertainties -- more so today than at most times in the past. The uncertainties take the form of the traditional (U.S. fiscal and monetary policy, interest rates and inflation) but also of the not-so-traditional (eurozone fiscal and monetary policy, the shadow inventory of homes and structural unemployment issues, the effect on personal spending from the ongoing screwflation of the middle class, the increased role of growth rates in emerging markets, fiscal imbalances, etc.). Equally significant, as I have been writing over the past few weeks, is behavioral economics -- for instance, the duration and intensity of the negative feedback loop on business (hiring and expansion plans) and on the consumer (spending and investing plans). Furthermore, the unpredictable (both to the upside and downside) role of high-frequency trading and leveraged ETFs is another wild card that makes forecasting even more difficult in the months ahead.

The wide range of possible economic outcomes (outlined below) is what makes forecasting so tough right now and is, regardless of the end result, a potential threat to overall market valuations. At best, it seems likely that earnings will be more volatile than the smooth pattern anticipated by the consensus. At worst, corporate profits will materially disappoint. Naturally, with outcomes so uncertain, the appropriate level of P/E multiples becomes less fixed, more difficult to forecast and, at times, will resemble a moving target.

I am building my baseline 12-month S&P 500 price forecast based on four different economic scenarios, applying a probability to each outcome and then assuming an expected market reaction under each case. (You, home-gamers, too, can use this outline and input your own assumptions and probabilities to personalize your forecasts.)

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.

I want to emphasize that this exercise is not intended to suggest precision of forecast -- for, as emphasized throughout today's opener, we live in a time of uncertainty of economic and investment backdrop. From the broad range of possibilities of a contagion of more Black Swan events to the chance of the adoption of intelligent pro-growth domestic policy, the substantially divergent outcomes translate to an equally wide possibility of S&P targets between 885 and 1500 (depending on the scenario).

In summary, "with the appropriate caveats," as Cisco's ( CSCO) John Chambers typically says in his quarterly conference calls, the above four scenarios and associated probabilities and market reactions attached to each produce a weighted 12-month S&P 500 price target of 1210, 33 S&P points, or only 3% higher than the close of trading on Friday (1177).

Doug Kass writes daily for RealMoney Pro , a premium service from TheStreet. For a free trial to RealMoney Pro and exclusive access to Mr. Kass's daily trades and market commentary, please click here.

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At the time of publication, Kass and/or his funds were long CSCO, 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.

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