Are market targets useful?Economic News and Analysis—
Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
and John Manley, CFA, Chief Equity Strategist
- Targets shouldn’t dictate your investments, but they should provide a reality check for your expectations.
- The best use of a target is to peel it back and look at the underlying environment.
- We see two risks in the near term—an overly aggressive Federal Reserve (Fed) and corporate profits rolling over. We feel both are unlikely.
"Life is a journey, not a destination." Ralph Waldo Emerson
In September 2012, we published a piece targeting 2,000 for the S&P 500 Index by the end of 2014. Now that the S&P 500 is flirting with 2,000, what should we make of our target?
At the time we published our target, the S&P 500 traded at 1,465. Earnings per share (EPS) for S&P 500 companies were $90. Now, the S&P 500 is flirting with 2,000 and EPS for the year could be $120.
How did we get here? Earnings have marched higher, and investors are willing to pay more for those earnings. It’s pretty simple, really—and that was the point of the target we published in 2012. It wasn’t a ridiculous, pie-in-the-sky call on the market. We were just noticing that if analysts’ expectations for earnings grew at a 5% to 6% annual rate—while the average over the past 20 years was 6% to 7%—then the consensus expectation for 2015 EPS would reach $125. The average price/earnings ratio applied to forward earnings over the past 20 years has been 15.0 to 16.5. So we applied a 16.0 multiple to the $125 EPS number to get 2,000.
Our target was a way to provide perspective. Using modest assumptions, we were pointing out that we thought a lot of upside potential existed in the market. And that’s really what targets should do: provide perspective. Targets shouldn’t dictate your investments, but they should provide a reality check for your expectations. A key element in using a target properly is in knowing where the target came from. What were the underlying assumptions, and were those assumptions reasonable?
Peeling back a target to look at the underlying environment
The best use of a target is to peel it back and look at the underlying environment. In September 2012, a 40% price gain seemed reasonable. We thought skeptical investors, an accommodative Fed, persistent earnings growth, and moderate valuations came together to create a supportive environment for equity investors. That environment persists today, though investors are less skeptical and valuations are higher.
Sir John Templeton talked about how bull markets are affected when investors go from pessimism to skepticism to optimism to exuberance. There’s still skepticism among investors, thanks to periodic short corrections and constant media din about how this economy is ready to roll over. We think this bull market is transitioning from the skepticism to optimism phase. In September 2012, we put the upper end of the 2014 trading range at 2,100. That, we thought, would be a comfortably optimistic, but not exuberant, level.
Two risks we see in the near-trm direection of the equity markets
We see two big risks to the near-term direction of the equity markets. We view the first risk as highly unlikely and the second risk as only unlikely. The first risk is that the Fed will prematurely tighten monetary policy. Considering global economic growth is hardly robust and inflation is still below desired levels, it seems unlikely that the Fed will tighten monetary policy anytime soon. Also, because the Fed seems committed to transparency and moderation when it comes to removing monetary accommodation, we put the risks of a premature tightening by the Fed as not just unlikely but highly unlikely.
The second risk to the outlook is that corporate profits will peak. Yes, profit margins are high and likely have peaked, but that doesn’t mean profits have peaked. For profits to peak, costs would have to increase faster than revenues. Slow economic growth should keep revenues growing.
Costs aren’t likely to grow too quickly, in our opinion. The Fed won’t likely allow the costs of financing to rise significantly. Labor costs aren’t increasing much. After a few years of rapid commodity price increases, there seems to be ample supply to keep those prices from rising much. There has also been little evidence in the economic data lately of productivity (output per hour) growing. That leaves plenty of space for businesses to contain costs.
What we see for the S&P 500 over the next two years
It’s harder for us to make a bold call about where the S&P 500 will be in two years than it was two years ago, but we think it’s reasonable to expect to see the S&P 500 hit 2,500 before 2016 ends. This estimate is based on expectations for earnings to grow between 7% and 10% per year and for valuations to stay in the 15.00 to 19.33 range (which is what they’ve done 50% of the time since 1988). Think of this prediction so much as a target but as a perspective, which is hopefully more useful.
The views expressed are as of 7-21-14 and are those of Chief Portfolio Strategist Brian Jacobsen, Ph.D., CFA, CFP®, Chief Equity Strategist John Manley, CFA, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.