I’ll go ahead and put my neck on the chopping block now. I’ve never had a target before on the S&P 500 or Dow because I never saw much point in the exercise. Unless you were trading in futures or a passive index investor, what’s the point, right? I liked to think I am investing in companies and business prospects not broad unknowable market forces. The last twelve months have been trying though. It seems that the risk on risk off trade has been the place to be. Most stock pickers have underperformed the market. Why is that? Even notable legends trail the boring indices. It’s been an unpredictable market. Perhaps only predictable in that the trend is inexorably higher. If there was ever a proverbial wall of worry, this is the thicket to climb.
I can’t even begin to cite the things that can go wrong. It would take too long and you’ll probably see them all mentioned many times over during the Presidential debates. But the most likely macro outcome between now and the end of the year, is that Government controlled interest rates stay low and by association so do most others. With a 2% 10 year risk free Treasury interest rate, the market is just way too low based on one popular measure of valuation, the discounted cash flow model.
With 2012 two-thirds done, the pros see S&P 500 companies earning $100 to $105 this year according to the most recent issue of Barron’s. Based on the midpoint of that range, profits are expected to rise 5% from last year’s $97.82. The “top-down” crowd isn’t far off from its “bottom-up” counterparts, or industry analysts, who are forecasting corporate profits of $103.39 for the year. Let’s be conservative and take the low end of the range and project $100 next year for the S&P 500. That means at 1405, Friday’s close, the S&P 500 yields 7.1% That’s just way too high for a 2% 10 year risk free rate comparison. If 3.5% is the normal equity risk free premium the S&P 500 should yield more like 5.5%. In order for that to happen, the S&P 500 would need to be about 1818. That’s nearly 400 points higher and if you assume each S&P point is equivalent to about 8 Dow points, that’s a 3200 point move in the Dow. That’s a 28.4% rise and it seems just about right to me when I look at how many blue chip stocks are trading far below their discounted cash flow.
When the market has the potential to rise so much, the only way professional money managers can earn their keep is to stay fully invested. With the world as as dangerous a place as it seems, that’s a bold and controversial stance. And it’s also a very difficult thing to do for a long short equity fund manager such as ourselves. It’s a distant memory now but that’s pretty much the way the 80’s and 90’s played out. If you weren’t fully invested you were left in the dust. Could that be happening again? Stranger things have happened before.