Wall Street Strategists’ Forecasts . . .
As we head into an action-packed final third of 2012, Wall Street strategists are taking a cautious view of the U.S. stock market. But if the election in November brings more pro-business policies, stocks may beat low expectations over the next year as PE ratios expand. Based on data just published in Barrons, twelve top equity strategists, hailing from both the “sell side” and “buy side” of Wall Street, are forecasting:
- 2012 S&P 500 EPS of $102.25. This is reasonable but probably still too high. The bottom-up estimate (reflecting analysts’ estimates for the 500 companies) is $103 but is likely to fall further over the next six months given weak growth in virtually every corner of the globe except Washington DC.
- 2013 S&P 500 EPS of $108, implying 5.6% earnings growth next year. This is also a bit too high, given very elevated profit margins that won’t climb further in a weak economy. However a number like $106 is reasonable; it only requires stable margins, low single-digit revenue growth, and a 1-2% decline in share count driven by share buy-backs.
- The strategists’ year-end 2012 price target is 1425, implying a trailing PE of 13.8x and a forward PE of 13.2x (all based on median forecast of the 12 strategists).
. . . Are Consistent with a 7.5% Total Return Over the Next Five Quarters
Let’s suppose the strategists’ forecasts for EPS are a little high and their forecast for PE is reasonably accurate. What does this imply for investors’ total return between now and year-end 2013?
- If we assume that 2013 EPS is $106 (only slightly below current forecasts) and that the year-end 2013 trailing PE is 13.8x (i.e., same as 2012), then the S&P 500 would be at 1463 by year-end 2013.
- In addition, based on my fairly bullish view of dividends, the index should pay a Q4 2012 dividend of $7.47 and a 2013 dividend of $34.50, or $41.97 over five quarters.
Using a current price for the S&P 500 of 1400, price appreciation by year-end 2013 would be $63 (1463 minus 1400) and total dividends would be $41.97, for a total return of 7.5% — (63 + 41.97) / 1400 = 7.5%. That is quite attractive when interest rates are so absurdly low. The primary down-side risk, which is certainly non-trivial, is that Washington takes the U.S. economy over the fabled “fiscal cliff.”
The Upside Risk from Pro-growth Policies
But we should not lose sight of upside risks as well. Wall Street’s strategists are using PE assumptions that are very conservative by historical standards, particularly considering that we are in a low-inflation, low-interest rate environment. From 2003 through 2007 the average trailing PE of the S&P 500 was 17.3, or 3.5 points above strategists’ assumptions discussed above. The average forward PE, 2003-2006, was 15.2x, or a full 2 points above current assumptions.
If investors become even modestly more positive about the future of the U.S. economy, PE ratios could expand from current low levels. And modest expansion could have a big impact on stock prices; you don’t need a full reversion to historical norms to get significant upside. For example, if at year-end 2013 the trailing PE was 15x rather than 13.8x (still well below the 2003-2007 average of 17.3x), the S&P 500 would be trading at 1590 and total return over the next five quarters would be 16.6% rather than 7.5%. (The calculation is: 1590 – 1400 = $190 in price appreciation, plus $41.97 in dividends equals a total return of $231.97; 231.97 / 1400 = 16.6%.)
Why Romney Ryan Could Boost the PE
As discussed in my July 9 post “The Other Keynesian Paradigm,” the poor recent performance of the U.S. economy can be traced to the “great suppression” of capitalistic “animal spirits” by the Obama Admnistration. Even if one is properly skeptical of the more grandiose elements of the Romney-Ryan agenda, it is not hard to envision them carrying out enough pro-business policies to lift the PE ratio modestly. These likely would include:
- Boost morale by ending the “spread-the-wealth” “you didn’t build that” rhetoric, in favor of a pro-growth “we can do this” message.
- Cut back on regulation, beginning with the EPA’s war on fossil fuels and at least curbing the impact of Obamacare and Dodd Frank. Because the Supreme Court has deemed Obamacare’s “individual mandate” a tax, it can be repealed in the Senate with just 51 votes.
- Corporate tax reform that cuts the top rate to 25%, broadens the tax base, and shifts to a “territorial” system of taxing the foreign profits of U.S. multinationals. This may sound ambitious but it is really a “no brainer,” recommended by Obama’s own Simpson Bowels Commission and similar to how nearly every other developed nation taxes corporations.
- Tax reform would likely include an incentive for companies to repatriate cash “stranded” overseas. Because the cash would be taxed at a low rate, this initative would not cost Uncle Sam much, but it would be very positive for shareholders because the repatriated cash would be spent on dividends, buy-backs, M&A, and capital investment.
- Another “no-brainer” reform, which Romney unwisely does not discuss much even though he touts it on his campaign website, is H1-B Visa reform allowing many more of the “best and brightest” immigrants to work in the U.S. after getting engineering and scientific degrees from American universities. This would improve Republicans’ standing with immigrants and could not easily be opposed by Democrats in Congress. (Obama has opposed it, over the objection of his Silicon Valley supporters, on the grounds that it should be part of a comprehensive immigration reform package.)
These reforms would raise “animal spirits” in the private sector and lift PE ratios on Wall Street. Although gloom is currently fashionable, an optimistic turn is not hard to envision because there are many positive developments in the U.S. economy that are not receiving the attention they deserve. The housing sector has bottomed and is starting to grow again. Households have delevered, with liabilities down 5.7% since 2007 while financial assets are up very slightly. State and local governments are also balancing budgets successfully, with only a few defaults. The North American energy boom could make the continent nearly energy independent in a few years; cheap and secure energy would lure manufacturing back to the U.S. And, in contrast to the dark days of the early 1980s, U.S. corporations are highly competitive globally in a great many industry sectors, including:
- Electronic technology, ranging from chips to servers to smart phones to software
- Consumer brands, from Coca-Cola to Harley Davidson
- Finance; yes, Wall Street is in disarray, but EU banks are in much worse shape.
- Energy, including sophisticated services
- Pharmaceuticals, biotech, and medical equipment
- Agriculture (including seeds, chemicals, and equipment)
- Aerospace, both civilian and military
- Capital goods ranging from electrical equipment to trucks to gas turbines
- Retailing, from Wal-Mart to Tiffany to Amazon
- Entertainment, from Disney to Wynn Resorts
The Table below shows the 2006-2011 growth rate for selected categories of U.S. exports. It’s an impressive performance, considering it spans the worst economic downturn since the 1930s.
Bottom Line
Although the Fiscal Cliff does pose a risk, the “base case” for equities of 7.5% total return over five quarters is attractive, and stocks could deliver a significantly higher return if Washington’s economic policies improve.
