Market Forecast: Bound and Bumpy
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.