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%).
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.