Market Forecast: Bound and Bumpy

This column originally appeared on Real Money Pro at 8:41 a.m. EDT on April 16.

NEW YORK ( Real Money) -- Last Tuesday I increased my calculation of the S&P 500's fair market value from 1335 to 1360.

With the S&P cash index closing at 1370 on Friday, the market appears muddle-valued.

In my calculation of fair market value, I recently increased the terminal P/E ratios attached to my four economic outcomes by half a multiple (0.5), reflecting my expectation of a more benign inflation rate and a slightly lower interest rate assumption for the year relative to my prior projections. In addition, I lowered to zero the probability of a reacceleration to above-consensus growth (3.0% real GDP or more), I slightly increased the possibility of sub-1.5% real GDP and raised the likelihood of my baseline, muddle-through economic scenario (of 2012 real GDP growth of between 1.5% and 2.0%).

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.

My base case of muddle through, with a 65% probability, yields an S&P 500 price target of 1430, 4% higher than S&P's current cash level (1370). Below-consensus economic 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 1370 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 70 S&P points of risk from the current S&P cash index and only about 60 points to the upside, for an uninspiring 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 135 S&P points down to only about 60 points up from Friday's closing S&P cash of 1370.)

In terms of the economy, the domestic economy was not as strong as portrayed over the last six months. Fourth-quarter 2011 economic growth benefited disproportionately from an inventory build and the termination of the 100% tax credit for capital expenditures (which was reduced by half on Jan. 1, 2012). First-quarter 2012 activity was elevated by unseasonably warm weather that pulled forward and buoyed retail spending.

The domestic economic outlook is less certain over the remainder of 2012, with the pull forward in activity over the last two quarters yielding to an undefined payback in the immediate period.

  • Economic growth outside of the U.S. is slowing, and with it, U.S. export growth will moderate.
  • Government spending (local, state and national) is retrenching.
  • The residential real estate market is slowly coming out of its funk.
  • Banks are liquid but cautious.
  • Financing for the largest corporations is cheap and available -- but less so for small businesses and consumers.
  • Debt-laden households are still deleveraging, and real disposable incomes are still flat-lining. (Savings rates are being drawn down which is likely to restrain retail spending.)

In the fullness of time, pent-up demand will be unleashed (as is currently the case in the automobile industry), but the timing is uncertain (particularly with elevated gasoline prices). On the other hand, the reduction in the price of natural gas has led to lower energy usage, and recent signs of slowing growth suggest that inflationary pressures will be easing.

If the domestic economy falls further than consensus forecasts, moderating inflation lays the groundwork for more Fed easing. In this case, the June-end monetary cliff would be less dangerous.

At the same time, the fiscal cliff at year-end poses much risk to the markets and to the U.S. economy. Currently, the constitutionality of the health care law is being decided by the courts. But even more important is the political gridlock and paralysis in Washington, D.C., which puts a pause on spending and tax decisions until after the November election (at the earliest). Even if there is some smooth solution to the vexing year-end tax and government spending issues (that will potentially result in more than a 3% hit to GDP and could trigger a recession), the structural deficit will grow ever larger, and a confrontation regarding the federal debt ceiling lies ahead.

It should not be surprising that the business community, facing numerous economic, tax and political uncertainties (after having already experienced a halving in the business tax credit on Jan. 1, 2012), is tentative and restrained in making meaningful and effusive capital spending and hiring decisions.

Then there is the long tail of the European debt crisis. Though, to some, 2012 doesn't feel as bad as 2011, Spain's woes likely represent the greatest systemic challenge to the eurozone since the contagion began, and it is hard to see the market making much headway until there is some meaningful resolution. (The next data point for Spain is Tuesday morning's remarks by Mario Draghi, in which we might receive hints regarding ECB policy options involving more LTROs or even an activation of the SMP.)

The consensus is that Spain muddles through with an ECB firewall. We'll see.

Over there, the first round of the French elections takes place this Sunday. François Hollande continues as a favorite over Nicolas Sarkozy, which would be an unfriendly development for the French economy and could even upset policy aimed at firewalling the debt problem.

Finally, China's landing (soft or hard?) remains in doubt and is still subject to interpretation.

Reflecting the growing ambiguity of the domestic economic recovery's trajectory and some of the other concerns (above), the S&P 500 is now off by nearly 4% from its high of 1422, but it is still up 9% year-to-date. The market indices have dropped for two consecutive weeks, something that hasn't happened since February as investors have grown skittish. Volatility appears to be on the ascent, with 1% daily moves in the S&P 500 last Monday, Tuesday, Thursday and Friday indicative of a lack of overall conviction on the part of market participants.

In summary, growing uncertainties point to a trendless market contained in a range between 1300 and 1430 on the S&P 500, with plenty of volatility and opportunities for traders but with more limited fortune likely presented to longer-term investors.

The skies are still not clear and will likely remain cloudy as incertitude remains on the front burner.

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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