EmailThere is a strong rationale for expecting 2012 to produce a very large gain for the stock market. The fundamentals are bullish. If a massive European-related debt market crisis does not develop, the S&P could be in line for a gain well into the double digits.
Coiled
Earnings for the S&P 500 companies in aggregate were up 14% in 2011 (using conservative estimates for the fourth quarter).
The S&P 500 index was flat.
If earnings rise just 6% in 2012 (which would be considerably lower than current projections of 10%), that would produce an earnings increase of 20% over the two-year period encompassing 2011 and 2012.
The S&P 500 could therefore rise 20% in 2012 following a flat 2011 and valuation metrics would merely return to the end-of-year 2010 levels -- when stocks were cheap.
Specifically, the earnings yield on the S&P was 6.8% at the end of 2010. That equates to a price/earnings ratio (P/E) of 14.7. If the S&P 500 index rose 20% in 2012 alongside a 6% rise in earnings, the S&P 500 index would end 2012 with a P/E back at just 14.7 -- the same level as a year ago, and well below the historical average of about 16.
To repeat -- even using a conservative assumption of 6% earnings growth in 2012, the S&P 500 would have to rise 20% in 2012 just to get the P/E ratio back to where it was a year ago.
The flat stock market in 2011, despite strong earnings growth, has left the market coiled to spring sharply higher in 2012 -- provided the European debt crisis does not explode into a massive problem.
Current Valuations
The S&P 500 as of December 31, 2011, has a stunningly high 7.8% earnings yield based on the past four quarters earnings (using a conservative fourth quarter estimate). That translates into a P/E ratio of 12.8.
The high earnings yield (low P/E) reflects tremendous value from a historical perspective, and even more so when compared to yields on treasuries.
The chart below compares the yield on the S&P 500 to the yield on the 10-year Treasury note over the past 25 years.
The recent divergence is stunning. Stock yields, relative to bonds, are of far greater value than at any point in decades. By a lot.
The divergence will only return to historical levels by rising stock prices (producing lower earnings yields), higher bond yields, lower earnings, or a combination of the three. There is always some risk of a recession and lower earnings, but the most likely outcome in our opinion is a combination of higher stock prices and, over a period of years, higher bond yields.
The excellent value in stocks is also indicated by the chart below. This chart relates to the discussion above about how stock price gains have lagged earnings growth, but covers ten years.
This chart implies that the S&P 500 already should be near 1500 just to have kept pace with prior years' earnings gains.
Together, these two charts indicate that stocks prices reflect greater than normal historical value relative to alternative investments and to recent earnings trends.
The Problem
There is a simple reason why stock price gains have not kept pace with earnings and why valuations are so low -- fear.
There are fears that a recession in Europe will cause a recession in the U.S. There are fears of a European credit freeze that will spark a 2008-like decline in the stock market. Perhaps there are even fears that the end of western civilization is nigh due to huge, unsolvable government budget deficits (see gold prices).
These fears are fed daily on TV, taken advantage of by traders who are short the market, and fueled the extreme volatility of 2011.
The fears have some justification. The problem, however, is that the risks of a severe European recession or a credit implosion are impossible to quantify. It is our view that the market has priced in far too great a likelihood of a major catastrophe. In fact, it is arguable that recession and a credit implosion are almost already priced into the market.
What If…Things Actually Turn Out OK?
Imagine, for example, that by the end of 2012 the market has come to believe that the European debt crisis will be controlled. That is, that no credit implosion will occur. There will be no severe recession, only a continuing (perhaps for years) mild recession in Europe due to the need for ongoing government austerity measures.
If that is the case, the impact on the U.S. economy and corporate earnings will be marginal. In fact, our forecast for real GDP growth in the U.S. of 3% in 2012 assumes a flat European economy. The U.S. is simply not that tied to European growth such that even a mild European recession will have that much impact on the U.S.
The impact on U.S. corporate earnings will also be marginal. So long as U.S. earnings continue to rise, in fact, the valuation argument remains intact.
Continuing problems in Europe that do not explode into a credit crisis will have no more impact on the U.S. than they did in the second half of 2011 -- when real GDP rose at a 3% annual rate and earnings grew at over a double-digit rate.
Consider what another year of decent U.S. economic growth would do to expectations. Talk of a double-dip recession might finally disappear. Expectations that steady economic growth will persist could develop.
In such a scenario, it is entirely plausible to assume that the P/E for the S&P 500 in aggregate would rise. It could easily rise from the current 12.8 to 14.7, as in the discussion above, and even head towards 16 -- if not in a year, then perhaps over a few years.
Steady if unspectacular economic growth, another year of decent earnings growth, and P/E expansion as prospects for the future improve, would lead to a very strong year for the S&P 500 in 2012. A gain of 20% is very possible under this scenario.
This is the story you won't hear much. Instead, you'll hear yet another talking head on TV spouting about the risks associated with Greece, Italian bond yields, and French bank credit default swap spreads. There will be large down days in the stock market associated with such developments, seemingly proving that the outlook for the stock market is correlated with Europe. Yet, these fear-driven days will ultimately give way to the grinding underlying importance of the hard-core, bottom-line fundamentals of earnings and valuation.
What It All Means
There is no denying the risk in the stock market. The European debt crisis could worsen, spread, create recession, and drive earnings lower.
The risk of that happening, however, is small relative to what has already been built into stock prices. It has been thoroughly discussed.
On the other hand, the upside potential for the stock market based on a continuation of current economic and earnings trends is rarely examined.
Valuations are so low, particularly relative to bond yields, that any move towards historical averages will drive stock prices higher at a faster rate than earnings growth.
There is a much greater chance that the S&P 500 will rise 10% to 20% in 2012 than is widely, if ever, discussed. All it takes is for the fears over the European debt crisis to ease (not disappear), for present economic and earnings trends to continue, and for the stock indices to catch up to the earnings gains of 2011.
