Kass: Fair Market Value Update

This column originally appeared on Real Money Pro at 7:21 a.m. EDT on July 18.

NEW YORK ( Real Money) -- In large measure, the worsening macroeconomic situation in Europe, China and the U.S. is leading me to reduce further my calculation of the S&P 500's fair market value from 1430 to 1415, which is still about 4% above the cash level at Tuesday's close of trading (1363).

  • I am keeping the chances of the two tail events -- namely, a reacceleration of U.S. growth and a U.S. recession in 2013 -- at 5% each.
  • I am increasing the probability of sub-1.5% 2013 real GDP growth from 35% to 40%.
  • I am reducing the likelihood of my baseline, muddle-through scenario (defined as 2013 real GDP growth of between 1.5% and 2.5%) from 55% to 50%.

My base case of muddling through now holds a 50/50 probability and yields an S&P 500 price target of 1540, far higher than my fair market value calculation of 1415 and well above cash (1363). The probability of muddling through, however, has been lowered twice over the past five weeks and could move still lower in the next month, due to the continuation of a weakening domestic economy and the superficial bandages applied to the eurozone.

Below-consensus growth (scenario No. 3 below), which is now accorded an increased 40% probability (the second-highest), yields an S&P 500 target of 1290, below both the current level of S&P 500 cash (1363) and well under my 1415 fair market value estimate. (These two most likely outcomes account for a 90% probability.)

S&P cash closed yesterday at 1363. In all likelihood, I expect the S&P 500 to be contained within the range between 1290 and my fair market value of 1415 over the balance of the year, representing a slightly negative imbalance between reward and risk. This yields a generally underwhelming and less-than-compelling investment equation. Taken literally, this would mean that there are about 70-75 S&P points of risk and about 50-55 S&P points of potential reward. (In other words, there will be a premium on individual stock selection over market risk-on/risk-off decisions in the months ahead.)

Today's recalculation of my S&P 500 fair market value of 1415 is about 70 S&P points, or only 5%, from my highest calculation (of 1485) back in April.

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. It is intended more as a thoughtful guideline (of reasonable expectations/outcomes) than an exercise that should be taken literally. (I strongly recommend that subscribers input their own probabilities and outcomes in order to produce their own market expectations.)

Scenarios

Below are the criteria and methodology I use to evaluate the S&P 500 and upon which I conclude that fair market value is approximately 1415, or about 4% above Tuesday's closing quote of 1363.

Scenario No. 1 -- Economic Reacceleration Above Consensus (probability stays at 5%): 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 real GDP) as Governor Romney wins the Presidency and the Republican Party gains control of the Senate and regains the House. 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 27% upside over the next eight months. S&P target is 1725.

Scenario No. 2 -- Recession (probability stays at 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 34% downside risk over the next eight months. S&P target is 890.

Scenario No. 3 -- Below-Consensus Economic Growth (probability goes from 35% to 40%): 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 to $350 billion). The S&P 500 profit forecast for 2013 is reduced to levels slightly below 2012's results and below consensus at $98 to $100 per share, as corporations' pricing power is limited and profit margins are pressured. Stocks, valued at 13.0x under this outcome, have 5% downside risk over the next eight months. S&P target is 1290.

Scenario No. 4 -- Muddle Through (probability goes from 55% to 50%): The U.S. muddles through, with 1.5% to 2.5% 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 13% upside over the next eight months. S&P target is 1540.

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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