This column originally appeared on Real Money Pro at 8:45 a.m. EDT on May 29.NEW YORK ( Real Money) --
"The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell." -- Sir John Templeton
- I have slightly adjusted my S&P 500 fair market value downward from 1485 to 1455, but the market is still about 10% undervalued.
- A trading range of 1290 to 1455 seems probable for the balance of 2012.
- Reward vs. risk is favorable, with 4.5x more upside than downside.
- The world's stock markets are hostages to Greece, but I expect Merkel & Co. to step up.
- Successfully containing the eurozone debt crisis (or even evidence that the Greek Democratic Party will forge an election victory) will likely result in a spirited market rally.
ChangesLast month, I replaced my four 2012 scenarios with new 2013 economic, corporate profit and stock market outcomes -- it produced a S&P 500 fair market value calculation of 1485. Let's investigate what fundamental, sentiment and valuation changes have occurred since my last fair market value was updated four weeks ago.
- U.S. Economy: A Mixed Bag. Domestic economic data have been mixed relative to my expectations. First-quarter 2012 real GDP growth likely came in a tad under 2%, and second-quarter 2012 real GDP growth should be in the 2% to 2.5% range. Nevertheless, we still seem destined to muddle through with 2% real GDP growth in 2012-2013. Payrolls growth seems stuck at a slightly below consensus level, and the rate of growth in manufacturing activity is decelerating modestly. On the other hand, some major positives for global growth include the drubbing in commodities (a tax cut to the consumer and a prop to corporate profit margins, which opens the door for more stimulative monetary policy around the world), the improvement in housing (the sector represents the greatest divergence in economic series relative to consensus) and still-healthy/elevated consumer sentiment.
- Europe's Economy: On the Precipice? The continued debt crisis has resulted in much more risk to economic growth in the eurozone. Greece is moving toward a depression, Spanish yields have recently spiked, and even Germany's manufacturing PMI is falling (to 45.0). While I had expected Greece to exit the eurozone in 2013, there is now a distinct possibility that the nation's exit is imminent (particularly after its elections two weeks ago). The new Greek elections in mid-June will be telling as to what the future holds -- yesterday an opinion poll suggested the possibility of a win for the pro-bailout parties, which could ease concerns that Greece will exit the currency bloc. For now, the U.S. stock market seems hostage to European developments. Many, including Harvard's Niall "We Are About to Start the Second Half of Our Great Depression" Ferguson, are concerned that a European Lehman moment is at hand, but I continue to expect that eurozone authorities will ultimately move to create an FDIC-like facility to insure European bank deposits and will seriously consider floating euro bonds.
- China's Economy: Slowing but Not Yet a Hard Landing. A soft landing seems the base case scenario, but there are emerging question marks (e.g., seven months of lower PMIs and lower energy consumption statistics).
- Corporate Profits: Still on Tap for $100-Plus S&P 500 EPS in 2012 and Further Growth Seen in 2013. Approximately one-sixth of aggregate S&P profits come from Europe, but most of our corporations' European sales/profits are derived from the strongest members of the eurozone. Over there, eurozone real GDP growth is likely to be down by less than 0.5% in the first half of 2012; the second half is problematic, and visibility is weak into 2013. The U.S. remains the best house in a bad neighborhood -- with 2% real GDP growth and 2% inflation, nominal GDP growth is likely to be over 4% this year, translating to 5% to 7% sales and profit growth.
- Investor Sentiment and Expectations: Low. The known negatives seem increasingly discounted: a month of near-double-digit market losses, a flopped Facebook (FB) IPO, the disclosure of a large derivative loss at JPMorgan Chase (JPM) and a possible Greek exit from the eurozone. Contrarian alert: The domestic equity fund outflows in the first half of the month of May were more than 4.5x the average over the first five months of the year (which was a record) and even greater than the first five months of 2008-2009! Financial Times featured a cover story on "the death of equities," which is another sign that we are at a negative sentiment extreme. Meanwhile, trading volume is evaporating, down 7% last week (over the prior week), down 30% year over year and down 40% below its peak in 2010. Frankly, if someone had told me year ago that the U.S. would be growing at a 2% real GDP rate, with a 1.75% 10-year U.S. Treasury yield, I would probably have projected a market P/E closer to 16x-17x vs. to the current 13x. Stated simply, stocks have become an unpopular asset class.
UpdateToday I have updated the probabilities of the four outcomes to reflect the five changing conditions above. In large measure, the worsening situation in Europe is leading me to reduce my calculation of the S&P 500's fair market value from 1485 to 1455, which is still more than 10% above the cash level at last Friday's close of trading (1317). Here are the changes to the four outcomes:
- I am decreasing the probability of an above-consensus reacceleration in domestic economic activity (defined as 3% or more 2013 real GDP growth) from 15% to 5%.
- I am leaving unchanged the chance of a U.S. recession in 2013 at 5%.
- I am increasing the probability of sub-1.5% 2013 real GDP growth from 20% to 25%.
- I am increasing the likelihood of my baseline, muddle-through scenario (defined as 2013 real GDP growth of between 1.5% and 2.0%) from 60% to 65%.