The January 3, 2012, Big Picture column titled “The Bullish Alternative” began with this statement:  There is a strong rationale for expecting 2012 to produce a very large gain for the stock market…the S&P could be in line for a gain well into double digits.

That still holds true. In fact, despite a continued high level of risk, the S&P 500 is on track to post the third largest yearly percentage gain in the past thirteen years. There is room for more upside in the years ahead.

Checking in at the Midpoint

The S&P 500 is up 8.3% so far this year. It isn’t a difficult computation, at this halfway point, to recognize that is an annual rate of increase of 16.6%.

Here are the changes since 1999 for the S&P 500 index (not including dividends):

The stock market has had a very good run the past three years and is up 105% from the lows of March 2009.

The Value Proposition Holds

The driving factor for the market the past three years has been earnings growth. Yes, earnings have rebounded strongly since the recession of 2009 despite lackluster economic growth.

Earnings growth the past three years has exceeded stock market gains. As a result, the already excellent value in stocks has improved even further. This year, however, stock prices are starting to catch up a bit.

As the January 3 Big Picture article noted, the S&P 500 was flat in 2011. Yet, aggregate profits for the S&P 500 were up 14% last year. That meant that the market was “coiled” to spring higher this year on any improvement in earnings. And that is exactly what has happened.

Earnings in the first quarter of this year were up 8% for the S&P 500 in aggregate over the first quarter of 2011. Earnings are expected to be up a similar amount for the second quarter.

Earnings are thus tracking for about an 8% gain for 2012 through the first half of the year. That is less than the 16% annual rate of increase in the S&P 500 index. Stock prices are in the process of catching up (at least a bit) to the recent earnings gains, but there is further to go.

The price/earnings (P/E) multiple on the S&P 500 through estimated second quarter earnings now stands at 13.3. That is a 7.5% earnings yield. The year-ahead P/E on the S&P 500 is just 12.4, for an earnings yield of 8.2%.

The current P/E is low relative to historical values and the earnings yield is thus higher than historical norms. The earnings yield is particularly high when compared to alternative yields.

The chart below shows the extreme divergence between bond yields and stock yields that has occurred over recent years.

Stocks represent tremendous value relative to bonds given the substantially higher yields.

The chart below further shows that stock gains in recent years have not kept pace with earnings gains. If the historical pattern between forward earnings projections and stock prices had held, the S&P 500 index would be at 1650 today.

The reason that stock prices remain depressed compared to historical norms is well known. It is fear. The fears can be separated into two categories – one possibly decreasing, the other increasing.

Risk #1 – European Debt (Decreasing)

The situation in Europe hardly needs explanation. It is well known. There are fears that a credit implosion will occur similar to what happened in the US after the Lehman debacle. There are also fears that a debt overhang, even without a credit market implosion, will dampen European economic growth for decades, with intermittent recessions.

The economic and recession fears are well justified. The credit collapse fears have been eased by the recent moves in Europe toward coordinated solutions.

There is plenty of analysis on these issues, and we’ll just jump to our conclusion that a great deal of the risk on both issues is already built into US stock prices. Concerns over these risks could ease through year-end, providing a supportive factor for US stocks.

Risk #2 – US Economic Trends (Increasing)

There is an increasing risk that the US economy will underperform and possibly re-enter recession.

Our second quarter real GDP forecast has been lowered to just a 0.7% annual rate of growth. The monthly numbers have been very disappointing. The trends do not appear to be aberrations.

Virtually every sector of the economy is slowing down. Consumer spending, employment growth, factory orders, consumer confidence, exports, and government expenditures have all been weak. The only real upside surprise has been residential housing, which is bouncing solidly off very low levels.

The outlook for the second half of the year is for these trends to continue, with real GDP growth remaining sub-par – perhaps near a 2% real annual rate.

This means second half earnings growth could be lower than currently expected.

First half earnings growth for the S&P 500 in aggregate, as noted above, is likely to be close to 8% over the same period last year. That is good, but the aggregate numbers mask some worrisome trends.

First quarter earnings growth of 8% would have been just 5.7% were it not for Apple’s massive profit growth. Those earnings certainly count, and if consumers had not been spending on Apple, they might have spent elsewhere. But it is also true that, for most companies, first quarter earnings growth was sluggish.

Second quarter earnings will remain sluggish for most companies. Bank of America posted a massive loss in the second quarter of 2011, and the absence of that loss this year means a huge earnings increase for 2012. Yet, it is arguable that Bank of America hasn’t generated sustainable underlying earnings growth.

More importantly, excluding Bank of America, aggregate second quarter earnings growth is expected to be a mere 1%.

That means that in both the first and second quarters, most companies hit the earnings wall. Current forecasts are for S&P profits to rise at a continued 8% rate in the second half of the year, but there is a very large and increasing risk that earnings growth will disappoint in both the third and fourth quarters.

US economic growth is slowing down at a time when the vast majority of companies are struggling to post any significant earnings growth. This risk is increasing, and has not received as much attention as deserved given the understandable current tunnel vision the global markets have for everything European.

What It All Means

The upside potential in stocks is larger than it has been for decades. The risks are also extremely high.

This high-risk/high-reward outlook means that stock portfolios must be viewed from an individualized standpoint to an even larger extent than normal.

That is, a portfolio must be fashioned to the specific risk-reward profile of the owner.

Young investors only recently investing in a 401k plan, for example, have few assets at risk currently, but have an opportunity to reap outstanding historical returns over the decades ahead. A reduction in asset values due to a drop of even 20% in the stock market will only impact a small percentage of the long-term projected value, while at the same time allowing more stocks to be bought at lower values.

The risk is low and the potential reward large. Current conditions are outstanding for young investors with a long-term vantage point. It is the opportunity of a lifetime.

A more mature investor with a substantial percentage of projected long-term assets already invested is in a different scenario entirely. A 10% drop in the stock market in the near term could be devastating. If so, the high risks warrant a defensive approach to the market. Briefing.com and the Big Picture have frequently presented the case for high quality, high dividend blue chip stocks for those concerned about the current risks.

From a tactical standpoint, there is also the seasonal risk that the Big Picture has frequently noted. The six months from May through October have vastly underperformed relative to the November through April period over the past fifty years. Volatility can be very high during the summer months.

Last year, for example, a US fiscal standoff precipitated a sharp August decline. The US is headed for another fiscal showdown which has the potential to roil the markets even if fears in Europe abate.

The stock market has had a great first half, despite recent volatility. The second half of the year could bring continued volatility, particularly in the immediate months ahead. Nevertheless, over the long term, conditions in Europe and the US will settle down, and allow stocks to capture the latent value that has been building up over recent years.

Dick Green

Founder and Chairman, Briefing.com