Newsletters 2011 Newsletters Outlook for 2012
Friday, 16 December 2011 11:23
After October’s surge, the stock market turned in a mixed performance in November with the Dow Jones Industrial Average up by 0.76% and the S&P 500 Composite and NASDAQ Composite down by -0.51% and -2.39% respectively. For the year, the Dow Jones is higher by 4.04% while the S&P 500 and NASDAQ are down by -0.94% and -1.23%. The composite of all Osher Van de Voorde equities under management is up by 2.28% for the year through November month-end.
Last December, we summarized our prognostications for how the stock market might fare in 2011 as follows:
“2011 annual earnings for the S&P 500 Composite are presently expected to come in at $94.52. At its current level of 1240, the S&P 500 trades at 13 times next year’s expected earnings and at just under 15 times 2010’s $83.59 full-year estimate. With interest rates at such historically low levels, corporate balance sheets in such wonderful shape and with the economy sustaining itself at “Goldilocks” levels, a PE of 15 seems easily justified and a premium PE might even be warranted. Applying no premium to account for our new obstacles, the S&P 500 should be able to maintain an approximate 15 PE and so trade up to 1418, an approximate 15% increase from current levels. Our initial 2011 target range for the S&P 500 is between 1400 and 1425, an expected gain of 13% to 15%.”
With the S&P 500 trading near 1225, It will take an extraordinary Santa Claus rally to catapult the stock market anywhere close to our expected year-end targets. That said, the S&P 500 did reach an intra-year high of 1363 on April 29th, a mere 2.64% shy of our forecasted target range. Our willingness to sell into strength as the market reached those calendar highs has certainly helped our relative performance this year.
In evaluating what may have gone wrong with our expectations, it is interesting to note that the two primary ingredients that drive stock market valuations, earnings and interest rates, proved to be more favourable for stock market conditions than we had anticipated. With consensus earnings for the S&P 500 at $94.52 last December, today’s top-down estimates for 2011 stand at $98.91, with bottom-up estimates at $97.27. Clearly, our expectation for continued growth in earnings proved correct. Last December, the U.S. 10-year Treasury bond offered investors a yield of 3.52%. Today, the 10-year Treasury bond yields 1.92%, having reached an intra-year low of 1.70%. Interest rates not only remained “historically low”, they moved materially lower. With earnings higher than expected and interest rates lower than expected, especially in the context of such reasonable valuations, one might have anticipated a stronger outcome for the year.
At today’s level of 1225, the S&P 500 trades at a PE of 12 on 2011 top-down estimates and a PE of 11.6 on the $105.38 forward estimate for 2012. Instead of the potential for “premium” valuation, 2011 has witnessed a valuation contraction, mostly resulting from the European sovereign debt crisis that continues to dampen investor appetite for risk. So, are such low valuations appropriate and what do we expect for 2012?
Unfortunately, absent a newfound ability for market risks to decouple, it will be difficult for the U.S. stock market to warrant any premium valuation in the face of continued Eurozone uncertainty. Despite recent intervention by central banks worldwide and a recent EU summit that produced a renewed commitment to austerity and fiscal unity, automatic penalties for future offenders, a quickened timeframe for EFSF implementation and additional contribution of Euro capital to the IMF, Italian yields are rising and the Euro is trending lower. While the potential Euro-version of a Lehman Brothers collapse seems to have been taken off the table, the threat of rising sovereign yields remains. Unless German Chancellor Merkel softens her stance on the (inevitable?) issuance of Eurobonds or the EU can convince the likes of China and the IMF to pony up additional capital, the EU seems destined for a slow grind.
Further, 2012 will be marked by arguably the most important U.S. Presidential election in history, certainly in recent history. While one would think that the incumbent would take all necessary measures to boost a dull economy in an election year, it seems clear that any proposed measures would be at odds with Congress. Republicans and Democrats offer seemingly polar views on taxes, the role of government and government spending. As such, gridlock is unlikely to diminish, with both sides of the aisle calculating it best to postpone any heavy lifting until after the election. Absent the willingness to compromise, the markets will be left to focus on campaign promises and politics, handicapping the potential outcome with the fluctuations of each new poll.
There are many who argue that, rather than Europe, the core issue facing our stock market is the uncertainty surrounding future taxes, health care costs, deficits and interest rates, all issues that ultimately determine our future economic growth. With the parties so divided over long-term solutions and the best means to stimulate the economy in the wake of the worst financial crisis since the Great Depression, it is no wonder why the 2012 election looms so large.
All that said, as long as the U.S. economy avoids the dreaded double-dip recession, the stock market already discounts a whole lot of bad news – valuations have rarely been this attractive in such a low interest rate environment. The IMF predicts that global GDP will increase by 4% in 2012, with developed economies that account for 52% of predicted output growing by 1.9% and emerging economies growing by 6.1%. And the economic data here in the U.S. points to strengthening GDP growth in the fourth quarter, despite all the euronoise. An accommodative Federal Reserve, consumer resiliency, the Fort Knox condition of corporate balance sheets, benign inflation and a well-reserved banking system should serve to soften the blow from potentially disruptive, exogenous events. Further, as the IMF estimates illustrate, growth in emerging economies is helping Corporate America offset weakness in Southern Europe. The fact that China, the world’s largest “emerging” economy, is easing economic conditions to meet its target for 8% GDP growth in 2012 should help maintain this trend. Meanwhile, the indicated annual dividend yield for the S&P 500 rests today at 2.27%, well north of the yield on 10-year Treasury bonds.
In summary, we find the stock market particularly attractive relative to other asset classes, though we are expecting volatility to persist throughout 2012. Based solely on the most important fundamentals of earnings and interest rates, a market PE multiple of 15 is very reasonable. Applying a 15 PE multiple on 2012 forecasted earnings would result in the S&P 500 trading at 1580, a 30% increase from today’s depressed levels. While a breakout to the upside is probable in the coming quarters, the present trading range for the S&P 500 between 1100 and 1300 may persist until visibility improves in the Eurozone and perhaps until after the 2012 election results are tallied. Similar to our 2011 playbook, we will consider selling into strength during periods of euro-euphoria and pick up bargains when gloom is pervasive. In the very general directional sense, we expect that our 2011 prognostications have merely been postponed. Stocks offer compelling value.
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