looking ahead

Today is the last day of May.  In a normal stock market year (let’s define “normal” as a time when investors are neither euphoric nor ready to jump out windows on high floors in tall buildings), this is the time when equity investors begin to ponder what the following calendar year will bring.

Why so early?  No extremely compelling reason.  It’s just the way it typically works.  Equity markets are futures markets, after all.  And by this time participants will have already discounted much of what the current year is likely to bring and are asking “What’s next?”.

not normal everywhere, but definitely normal in the US

Conditions are by no means normal all around the world.  Europeans are scared out of their wits by the politics/economics of the EU.  Pacific Basin markets are keeping a close eye on China, while hoping the battering they’re taking from European selling will soon end.  In the US, in contrast, the economy is entering its fourth year of recovery.  Employment is stable-plus, compensation for regular employees (as opposed to CEOs, who always pay themselves well) is beginning to rise, and the housing market–a key source of wealth–is showing its first signs of life since 2007.  While daily price volatility may be high and the shrill noises from talking heads may be particularly bearish, I think 2012 is a normal year.

therefore, time for pondering 2013 to begin

(You may argue that pondering season has already started, and point to the 8% decline in the S&P since its intraday high on April 2nd as evidence.  I don’t interpret the data that way, but you may be right.  If so, you should be more bullish than I am, since you think Wall Street has been factoring bad news into prices for longer than I do.)

a few numbers

Let’s begin with a back-of-the-envelope (which is the best you’ll get from me) calculation.  According to Factset, Wall Street is estimating earnings of around $105 for 2012, up from $97 in 2011.

Let’s say S&P 500 eps will reach $110-$115 in 2013, which is roughly the consensus.

based on 2012 eps

If the market could trade at 14x earnings, a target for the S&P based on estimated earnings would be 1470.

The 1422 high of two months ago was about 3% below that, giving new money absolutely no motivation to buy stocks.  That also meant short-term traders had a reason to bet against a further rise.

Yesterday’s close was about 12% below 1470, suggesting the US stock market may be on more stable ground.

…and based on 2013 eps

The same calculation gives a target range of 1540-1610 for the S&P based on my guess about next year’s eps.  Potential appreciation from yesterday’s close would be +17% to +23%.

If you want to say that the US stock market continues to trade at the current multiple of 13x eps instead of 14x, then potential appreciation would be +9% to +14%.

In a world of 1.6%-yielding ten-year Treasuries, and 2.7% thirty-years, either case looks pretty good.

clouds on the horizon

I can see three, all of them the obvious ones:

1.  slowdown in China   For what it’s worth, as macroeconomics I think this is old news.  Policy is already beginning to move in a stimulative direction.  However, it will take some time for the new policy direction to take effect.  This probably means weaker prices for industrial commodities–and for commodity-dependent stocks–as well as for negative earnings surprises for firms whose profits are strongly linked to Chinese customers.  So China does have stock market implications.  But they’re stock selection ones rather than market-moving ones.

2.  ”fiscal cliff” in the US    On January 1, 2013, the temporary federal payroll tax cut is set to expire.  So, too, is the extension of Bush-era income tax reductions.  Large mandatory cuts in federal government spending, triggered by Washington’s failure to come up with an overall plan for deficit reduction, are supposed to happen as well.

This combination is enough to send the domestic economy beck into recession.

The consensus view is that after the election, the lame-duck Congress will do something to soften the blow.  My guess is the consensus will prove correct, although an accident is always possible.

3.  implosion in the EU    This is the main concern of global stock markets.

To recap:

–The crisis has been going on for almost three years.

–Worries have been discounted in waves of selling over that time, the worst of which (I think) have been the one currently in progress and the previous one last summer.

–The general parameters of a solution have been well-understood for a long time.

–I think Greece being in the EU or out is a big deal for that country but for no one else.

–The end game is unlikely to be a Japan-like fading of the EU into irrelevance, which would be bad for Europeans but ok for world equity markets.  Unaddressed, an outcome more like the 1996-98 crisis in smaller Asian markets is more probable.

timing?

Evidence to date to the contrary, I tend to think that the worst won’t happen.  I’d feel better about markets if I thought I were in the minority.  But if I were, I think global equity prices would easily be 10% lower than they are now.

If I’m correct, the main imponderable is the timing of a solution.  What little I know (or think I know) about politics says that when resolving a difficult issue involves sacrifice, the problem must be seen as so bad that solving it–no matter what the cost–can be presented to voters as a victory.

Are we at that point yet with the EU?  I don’t know.  Martin Wolf, chief economist with the Financial Times, has a good summary of the state of play.

Were the EU to show it finally has the resolve needed to adequately address its financial woes, however, I’m confident that the higher S&P targets for 2013 mentioned above would quickly become Wall Street’s game plan.  And a mini-version of last year’s autumn rally would likely occur.

In the meantime, markets will likely drift.