Kass: Fair Market Value Update

This column originally appeared on Real Money Pro at 7:53 a.m. EDT on Sept. 4.

NEW YORK ( Real Money) -- As I look toward the balance of the year, uncertainty seems to be the operative word.

Second-quarter reported EPS mostly met expectations, while top-line growth began to disappoint. Forward guidance, however, was conservative. I expect more pressure on corporate profits in the quarters ahead, as sales continue to slip relative to consensus amid the challenges mentioned in today's opening missive.

U.S. real GDP expanded at about a 1.8% rate in this year's first half. Domestic economic growth in July seemed to reaccelerate somewhat, but, with rising gasoline (now at an all-time Labor Day high) and food prices, a weakening in refinancing activity, and political uncertainty and fears of a fiscal cliff, aggregate growth appeared to moderate in August. The current indication is for similar real GDP growth in third quarter 2012, reflecting weakening capital spending orders (lower in six of the last seven months) to be offset by some improvement in real incomes (up 3% year over year) and a steadily improving residential real estate market.

Away from the U.S., two important growth drivers, Europe and China, are likely to prove a drag on (consensus) growth.

I Am Cautiously Pessimistic

I am concerned that, come the fourth quarter of 2012, the emerging freeze in capital spending orders will reverberate through the production channel and become a freeze on job creation, creating a rippling and negative impact on domestic economic growth. And, while the Fed chairman " has our back," I am less optimistic that most that the Fed's actions will result in the intended benefits.

Indeed, I believe that more easing could have a negative aggregate impact on the trajectory of the domestic economy. Some of the potential unintended consequences of another bout of quantitative easing include higher commodities prices, especially of an energy kind, as well as putting more pressure on the savings class.

With the likely projected course of domestic growth still subpar over the next two quarters, the recovery remains vulnerable to any of a number of external shocks, which could include Draghi not being able to deliver a recipe to reduce sovereign debt yields(and/or a coordinated growth plan for the eurozone), an Iran-Israel confrontation (and its unfavorable impact on gasoline prices), a Democratic presidential and Senate victory (seen as business- and market-unfriendly) and a harder-than-expected deceleration in China's economy (that would likely result in a sharp drop in commodities and a curtailment in China's participation in buying U.S. debt).

As mentioned in my last fair market calculation, the growth risks continue to be on the downside.

To summarize, in large measure, the worsening macroeconomic situation in Europe, China and the U.S. is leading me to modestly reduce my calculation of the S&P 500's fair market value from 1415 to 1390, which is about 1% below the cash level at Friday's close of trading (1407).

  • I am reducing the chances of the two tail events -- namely, a reacceleration of U.S. growth and a U.S. recession in 2013 -- from 5% to 2.5% each (or close to zero). I use 2.5% probabilities because almost no scenario has a zero chance of occurring.
  • I am increasing the probability of sub-1.5% 2013 real GDP growth from 40% to 55%. This scenario becomes my new baseline expectation.
  • I am reducing the likelihood of my previous baseline, muddle-through scenario (defined as 2013 real GDP growth of between 1.5% and 2.5%) from 50% to 40%.

For the first time this year, my base case now is no longer a muddle-through scenario (of 1.5% to 2.5% 2013 real GDP growth). Instead, my base case (with the greatest probability (of 55%) becomes a below-consensus (sub-1.5% real GDP growth). The S&P 500 forecast off my new base case yields a price target of 1290, well under my fair market value calculation of 1390 and that of Friday's closing cash price of 1407. The probability of muddling through has now been lowered three times over the past few months, due to the persistent threat of a potential weakening in the domestic economy, the superficial bandages applied to the eurozone and the continuing downgrade in the growth prospects for China.

Muddle-through growth (scenario No. 4 below), which is now accorded a decreased 40% probability (the second-highest), yields an S&P 500 target of 1540, well above the current level of S&P 500 cash (1407) and over my new 1390 fair market value estimate. (These two most likely outcomes account for a 95% probability.)

S&P cash closed at 1407 on Friday. In all likelihood, I expect the S&P 500 to be contained within the range between 1290 and 1420 over the balance of the year, representing a generally underwhelming and less-than-compelling investment equation. Taken literally, this would mean that there are about 115 S&P points of risk and only about 15 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 to 1390 compares to my highest fair market value 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 1390, or about 1% below Friday's close of 1407.

Scenario No. 1 -- Economic Reacceleration Above Consensus (probability goes from 5% to 2.5%): 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 23% upside over the next eight months. S&P target is 1725.

Scenario No. 2 -- Recession (probability goes from 5% to 2.5%): 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 Representatives. The schism between the two parties persists. Partisanship leads to rancor during summer debt-ceiling deliberations (instituted because of slowing nominal GDP) similar to the acrimony 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 eight months. S&P target is 890.

Scenario No. 3 -- Below-Consensus Economic Growth (probability goes from 40% to 55%): 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 8% downside risk over the next eight months. S&P target is 1290.

Scenario No. 4 -- Muddle Through (probability goes from 50% to 40%): 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 9% upside over the next eight months. S&P target is 1540.

At the time of publication, Kass and/or his funds were short SPY, although holdings can change at any time.

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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