A Fair Market Value Update

This column originally appeared on Real Money Pro at 7:41 a.m. EDT on April 10.

NEW YORK ( Real Money) -- I am fine-tuning my S&P 500 fair market value calculation.

As a reminder, my starting point in determining exposure is valuation: My fair market value calculation is based on four different economic scenarios and assigning probabilities to each result.

In looking at these four outcomes, I am making the following changes this morning:

  • I am lowering the probability of an above-consensus reacceleration in domestic economic activity to zero (defined as +3% for 2012 real GDP growth);
  • I am modestly increasing the chance of sub-1.5% 2012 real GDP growth; and
  • I am slightly raising the likelihood of my baseline, muddle-through scenario (defined as 2012 real GDP growth of between +1.5% and +2.0%).

I am also increasing the theoretical P/E ratios attached to each of the four economic outcomes by half a multiple (+0.5). This reflects my expectation for a more benign inflation rate and a modestly lower interest rate assumption in 2012 relative to my prior projections.

Based on those changes, I have slightly increased my calculation of the S&P 500's fair market value from 1335 to 1360.

My base case of muddle through, with a near two-thirds probability, yields an S&P price target of 1430, somewhat higher than my fair market value calculation of 1360. Below-consensus growth, which is accorded about a one-third probability, yields an S&P target of 1235, which is well below both the current level of S&P cash of 1382 and my 1360 fair market value estimate.

While there could be overshoots, in all likelihood, I expect the S&P 500 to be contained within the upper range of these two likely outcomes of between 1235 and 1430 for the remainder of the year. My guess is that 1300-1430 represents a reasonable trading range for the balance of 2012. (Remember the 1235 target has been assigned only about a one-third probability, so I adjust my trading range higher.) This yields about 82 S&P points of risk from the current S&P cash index and only about 47 points to the upside, for a slightly unfavorable risk/reward. (It should be noted, however, that in its extreme and not adjusting for the melded outcome probabilities, a much broader trading range (1235-1430) is represented, with a far more unattractive risk/reward ratio of nearly 150 S&P points down to only about 45 points up from Monday's closing S&P cash of 1385.)

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.

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 1360, or about 2% below yesterday's closing price of 1382.

Scenario No. 1 -- Economic Reacceleration Above Consensus (probability goes from 10% to 0%): The pace of U.S. economic recovery reaccelerates to above-consensus forecasts (3%-plus 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 housing recovering sharply, owing to the adoption of aggressive plans by the government to enact a massive home refinancing effort and deplete the excess inventory of unsold homes. Europe stabilizes (and experiences only a shallow recession), and China has a soft landing. S&P 500 profit estimates for 2012 are raised modestly to $106 to $110 per share. Stocks, valued at 15x under this outcome, have 17% upside over the next nine months. S&P target is 1620.

Scenario No. 2 -- Recession (probability stays at 0%): 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. A series of bank failures and sovereign debt defaults in the eurozone contribute to a deep European recession and a hard landing in China and India. S&P 500 earnings estimates for 2012 are materially slashed to $75 to $80 per share. Stocks, valued at 11.x under this outcome, have 38% downside risk over the next nine months. S&P target is 855.

Scenario No. 3 - Below-Consensus Economic Growth (probability goes from 30% to 35%): The U.S. experiences a disappointing sub-1.5% 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 12.5x under this outcome, have 11% downside risk over the next nine months. S&P target is 1235.

Scenario No. 4 -- Muddle Through (probability goes from 60% to 65%): 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 13.75x under this outcome, have 3% upside over the next nine months. S&P target is 1430.

Given that the market now appears reasonably priced relative to equilibrium, shorting premium through straddles and strangles makes some sense.

Unlike last year, however, during which nearly every stock and asset class seemed to be correlated, good stock picking will be the principal recipe for delivering good investment performance over the balance of 2012.
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.