Market Forecast: Bound and Bumpy

NEW YORK (Real Money) -- Last Tuesday I increased my calculation of the S&P 500's fair market value from 1335 to 1360.

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.