It is getting harder to forecast the direction of the stock market. A year ago there were still plenty of bears around and we expected the market to rise as cautious strategists, one by one, threw in the towel. Investors were pulled into a rising market, producing the “valuation levitation” we expected. Now confusion and disagreement have dissipated and there is a rather alarming unanimity that stocks are headed higher in 2014—even though the S&P 500 is already 7% above where strategists, as of four months ago, expected to end this year. Although the consensus is not always wrong, the risks of a stock market correction is higher, now that there are far fewer bears to convert.
Rising optimism is apparent in the latest Barron’s survey of 10 Wall Street strategists (to which I added the views of 2 other houses). The strategists have become more bullish since September and are in close agreement as to what 2014 will bring:
- They expect S&P EPS to rise 8.2% in 2014 to $118.3. Pretty much everyone agrees about this; of the 12 EPS estimates, 9 are in the range of $117.5-$120. The standard deviation of 2014 EPS forecasts is only half as big as in early September, when Barron’s took its last survey.
- Since September strategists have become more bullish on 2014 profits; $118.3 is 1.6% above the average forecast back in September.
- The average 2014 year-end price target is 1969, implying a trailing PE of 16.6x. This also reflects increasing bullishness; back in September they expected the year-end 2013 PE to be 15.7x.
- At 1810, the S&P 500 trades at 16.6x expected 2013 profits of $109.4. Back in September strategists’ average year-end 2013 target was 1700, or 15.7x expected EPS of $108. So strategists were too bearish on both profits and valuation.
- All the strategists like tech stocks, which I consider to be negative for the sector. It looks cheap, but for a reason. The big incumbents (e.g., ORCL, MSFT, IBM, CSCO) keep missing estimates because the Internet and cloud are disrupting their business models. There are good names in tech, but you have to be selective.
What should we conclude from strategists’ unanimous bullishness on the overall market?
Complacency has increased, and investors are carrying huge profits, so the market is vulnerable to bad news—particularly any evidence that the Fed won’t be as accommodative as expected. You don’t need a really good reason for stocks to trade down 15%. Keep some powder dry.
That said, my guess is that strategists are not yet bullish enough. We could well end 2014 above their average target of 1969. The dominant financial reality is that investors earn nothing on CDs and money market funds, and they earn very little from bonds, despite the price risk. With short rates unlikely to rise meaningfully before 2016, investors will continue to reach for yield in the stock market while companies, responding to shareholders’ wishes, raise dividends faster than earnings. (3M just raised its payout 35%!) Therefore I think the S&P 500 yield will remain 2%, and with dividends likely to be $41-$42 next year that implies a 2014 year-end price of 2050-2100. If profits are $120 the trailing PE would be 17.3x which is high but not ridiculous. It is only modestly above the current 16.6x, and of the 12 strategists, 4 have year-end 2014 trailing PE forecasts of 17.1x or higher. The economic pick-up in the U.S. and parts of Europe is positive for earnings; though I don’t expect a huge upside surprise, positive profit news is bullish for sentiment. And don’t forget politics. The Obamacare news will only get worse next year as millions of small business employees lose their plans and their doctors and are forced into inferior plans with higher premiums and deductibles. A big Republican win next November would be unambiguously bullish for stocks.
Copyright Thomas Doerflinger 2013. All Rights Reserved.
