Fair Market Value Update

This column originally appeared on Real Money Pro on April 30.

NEW YORK ( Real Money) -- I am substantially raising my calculation of the S&P's 500 fair market value from 1360 to 1485.

This will surprise many, as it is being done at a time during which some see similarities between the present day and the same time period in 2011, when, reflecting slowing domestic economic momentum and a rising crisis in the eurozone, the U.S. stock market began a period during which share prices began to decline.

It is my view, however, that there are more noticeable dissimilarities than similarities between late-April 2012 and April 2011.

  • Economic growth: Most observers are more cautious regarding domestic growth today, even though the recovery's breadth is better -- employment has improved, and there is a nascent recovery in the residential real estate markets. Consensus (worldwide) GDP forecasts (here and abroad) are far more reasonable today.
  • Profits: Corporate profit momentum has turned positive. Historically, the magnitude of the upward earnings revisions has been associated with a near-8% rise in the U.S. stock market over the next six months (and by year-end).
  • Housing: The outlook for housing is markedly improved. Household formations are recovering, and the NAHB Index and buyer traffic are at five-year highs while inventories are at five year low. The role of residential real estate markets cannot be overstated. Representing a third of household wealth and nearly half of bank assets, housing could add almost 1% to GDP in 2013.
  • Durable spending: Other types of durable spending are returning -- for instance, autos industry sales have risen sharply to a four-year high.
  • Household health: Household leverage has moved lower -- household debt/GDP has returned back to the long-term average.
  • Employment: Employment indicators have improved relative to a year ago. Claims data are lower, and ISM employment components are consistent with monthly payroll gains in excess of 200,000. Hours worked are expanding at a 4% annualized rate.
  • U.S. monetary policy: 2012 is highlighted by massive global easing of monetary policy and excessive liquidity. Central banks were generally tightening 12 months ago.
  • European monetary policy: Europe's central bank has lost its obsession with inflation and austerity and has begun to pay more attention to the capital markets and economic growth.
  • Commodities: Commodity prices are falling year over year (by 15% to 20%). A year ago commodity prices were rising. Even the price of oil has risen less than experienced in 2010-2011. (It rose by 75% from summer 2010 to May 2011.)
  • Banks: Banks have materially recapitalized and have passed stringent stress tests.
  • Balance sheets: Corporate balance sheets continue to improve and remain rock solid. Debt is low vs. the same time a year ago and liquidity is higher.
  • Investor sentiment: Investors remain risk-averse. Unlike last year, investors are no longer aggressively positioned toward economic growth or markets. Inflows into domestic equity funds are lower through the first four months in 2012 compared to the beginning of 2011, and hedge funds' net long exposure is lower this year than a year ago.
  • Valuations: Valuations remain subdued, and the earnings risk premium is still elevated.
  • Europe: European stress indicators are lower, reflecting a ring-fencing of the debt problems and facilities that have been put in place to insure funding needs for the next few years as well as improving current account balances in Italy, Spain, Greece and Portugal. The cost of interbank lending risk is low and falling -- it was rising last year -- and short-term note yields in Italy and Spain are well off their highs.
  • Black swans: In 2011 exogenous events negatively impacted worldwide growth. Thai floods and the Tohoku earthquake disrupted supply chains and hurt sales and resulted in nearly $100 billion of insurance losses.

With the month of May upon our doorstep and with the year nearly half over, I am now replacing the previously projected four 2012 scenarios with new 2013 economic, corporate profit and stock market outcomes in my S&P 500 fair market value calculation.

Based on those changes, I have increased my calculation of the S&P 500's fair market value from 1360 to 1485, or 6% above the cash level at last Friday's close of trading.

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

  • I am increasing the probability of an above-consensus reacceleration in domestic economic activity (defined as +3% or more 2013 real GDP growth) from zero to 15%;
  • I am modestly increasing the chance of a recession in 2013 from zero to 5%;
  • I am lowering the probability of sub-1.5% 2013 real GDP growth from 35% to 20%; and
  • I am slightly reducing the likelihood of my baseline, muddle-through scenario (defined as 2013 real GDP growth of between +1.5% and +2.0%) from 65% to 60%.

I am again 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 2013 relative to my prior projections.

My base case of muddling through, with a six in 10 probability, yields an S&P price target of 1540, somewhat higher than my fair market value calculation of 1485. Below-consensus growth, which is accorded less than a one-third probability, yields an S&P target of 1290, which is well below both the current level of S&P cash of 1403 and my 1485 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 (which account for 80% of the outcome probabilities) of between 1290 and 1540 for the remainder of the year. Taken literally, this yields about 113 S&P points of risk from the current S&P cash level and about 137 points to the upside, for a more favorable risk/reward.

As I have repeatedly written, 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 1485, or about 6% above Friday's closing S&P of 1403.

Scenario No. 1 -- Economic Reacceleration Above Consensus (probability goes from 0% to 15%): The pace of U.S. economic recovery reaccelerates to above-consensus forecasts (3%+ 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 durable spending (housing and autos) recovering sharply as pent-up demand is unleashed. The $550 billion fiscal cliff is whittled down to only about $150 billion (subtracting less than 0.5% from 2013 peal GDP) as President Obama (the incumbent wins) and a Republican Congress learn to compromise on taxes, entitlements and deficits. Europe stabilizes (and experiences a shallow recession), and China has a soft landing (with GDP growth tracking in excess of 8%). There is no QE3. S&P 500 profit estimates for 2013 are raised to $110-$113 per share. Stocks, valued at 15.5x under this outcome, have 23% upside over the next nine months. S&P target is 1725.

Scenario No. 2 -- Recession (probability goes from 0% to 5%): 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. The Democratic Party regains the White House and the Senate, but the Republicans maintain control of the House of Representative. The schism between the two parties persists. Partisanship leads to rancor during summer debt-ceiling deliberations (instituted because of slowing nominal GDP) similar to that of August 2011. Confidence deteriorates further and the housing market seizes up as bank lending becomes more restrictive when the fiscal cliff is not remedied/addressed (the hit to GDP is -1.5% to -2.0%). QE3 is instituted but fails to contain the economic weakness. A series of European bank failures and EU sovereign debt defaults contribute to a deepening European recession and a hard landing in China and India. S&P 500 earnings estimates for 2013 are materially reduced to $75 to $80 per share. Stocks, valued at 11.5x under this outcome, have 36% downside risk over the next nine months. S&P target is 890.

Scenario No. 3 -- Below-Consensus Economic Growth (probability goes from 35% to 20%): The U.S. experiences a disappointing sub-1.5% real GDP growth rate, Europe experiences a medium-scale recession, and China's economic growth disappoints modestly relative to expectations. QE3 is initiated and has a modestly favorable impact on aggregate growth. Obama regains the presidency, and the Republicans control Congress. The fiscal cliff is reduced by less than half (to $275 billion-$350 billion). The S&P 500 profit forecasts for 2013 are reduced to levels slightly below 2012's results as corporations' pricing power is limited and profit margins are pressured, so S&P profit forecasts are cut back to below consensus of $98 to $100 per share. Stocks, valued at 13.0x under this outcome, have 8% downside risk over the next nine months. S&P target is 1290.

Scenario No. 4 -- Muddle Through (probability goes from 65% to 60%): The U.S. muddles through, with 1.5%-2.25% real GDP growth, and the European economies suffer a modest (but contained) business downturn. China's and India's economies grow in line relative to consensus forecasts. There is no further quantitative easing. Obama regains the White House, and the Republicans control Congress. The fiscal cliff is reduced by half (to $275 billion). S&P 500 profits for 2013 trend toward a range of $107-$109 per share as some modest margin slippage occurs (coincident with escalating inflationary pressures). Stocks, valued at 14.25x under this outcome, have 10% upside over the next nine months. S&P target is 1540.

At the time of publication, Kass and/or his funds had no positions in any stocks mentioned.

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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