Economic News & Analysis - April 23, 2012The rough road to 2015
By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist, and John Manley, CFA, Chief Equity Strategist
“If a man will begin with certainties, he shall end in doubts. However, if he be willing to begin with doubts, he shall end in certainties.” —Sir Francis Bacon
The day-to-day vagaries of the market can make investors lose perspective. If you “mark to market” your portfolio every day, the movements can make you feel richer or poorer, depending on the winds of the day. With April’s trading patterns calling the first quarter’s gains into question, the urge to “step to the sideline” can emerge and push investors to significantly reduce their equity exposure.But what about the longer-term view? What is a reasonable price for the S&P 500 Index in the next three years?
Evaluating growthLet’s use the International Monetary Fund’s (IMF) forecasts for nominal GDP growth. While the IMF isn’t always right, it’s a reasonable starting point. Starting with nominal GDP growth seems to be a good baseline for top-line revenue growth. From 2012 to 2017, U.S. nominal GDP is forecasted to grow by 4.66% per annum on average. The rest of the world’s GDP is forecasted to grow by 5.56%. While these numbers are not deeply pessimistic, neither are they wildly enthusiastic. They are calm, easily defensible projections.
U.S. companies’ revenue growth isn’t necessarily tied to U.S. economic growth. When more than 40% of S&P 500 companies’ revenue comes from outside the U.S., global growth becomes increasingly important when determining U.S. corporate revenue growth. We also think U.S. companies have the brand-name recognition and appeal that could help their revenues grow faster than simple global GDP. They can gain share in an improving world, meaning revenue could grow between 5% and 7% over the next few years.
To get from the top-line revenue to the bottom-line earnings, you have to consider costs. Businesses have been cutting costs, and we see no reason to think the cost-cutting craze will reverse significantly over the next few years. Further efficiencies can be found and implemented through the use of technology.Companies are also likely to buy back shares over the next few years as a way to use up cash if they cannot find more profitable reinvestment opportunities. Thus, earnings may grow in line with revenues, and earnings per share (EPS) could grow slightly faster.
For instance, if S&P 500 EPS grows at 5% to 6% per annum in 2013 and 2014, it should produce $125 in EPS by 2015. But how much should investors be willing to pay for those earnings? After all, investing is about the future rather than the past.
If that level of growth does occur, despite the events in the U.S. and Europe, and all the other worries in the world, we should be closer to fixing the problems instead of just papering them over. Current or soon-to-be-implemented draconian fiscal policies should have caused their pain and then delivered their intended cure. The world may be seen as emerging from chronic economic illness, which had produced regular fits of contraction and required the ongoing administration of painful and dangerous medicine.That could result in a more “normal” price-to-forward-earnings ratio of 16, putting the S&P 500 Index at around 2,000 entering 2015. That’s a 15% annual rate of return over two and a half years. If that return is back-ended, as we suspect it will be (in our mind, 2012 remains a flattish, “testing,” trading range year), the annual returns for 2013 and 2014 could annualize at 20% to 25%—well worth anticipating now, in our opinion.
There is some precedence for this scenario. In 1984, the markets tested the reemergence of inflation. The fear and skepticism of today was equally present then. However, the focus then was on the reemergence of inflationary problems, not today’s deflationary ones. That year began with fears of resurgent inflation but ended with a sense that inflation had been put away for good. A simple change in sentiment allowed multiples to rise dramatically, without a surge in earnings. What had made the market “cheap for a reason” no longer was an imminent threat. Like a cured patient springing from a sick bed, the S&P 500 Index surged over 50% in 1985 and 1986 as its price-to-earnings ratio returned to a more normal situation.
That’s not to say the road to 2015 is going to be smooth and steady. Markets rarely—if ever—move in a straight line. Even if 2012 ends close to where it started, the longer-term view suggests investors won’t merely be running in circles.