Thursday, November 01, 2012

Lots of Headwinds, But Stocks Will Continue to Climb in 2013

Hurricane Sandy’s Potential Economic Impact
Our thoughts and prayers reach out to the people of the Northeast and everyone who is affected by Hurricane Sandy. 
At this time, the estimated economic damage of this storm is $30-50 billion.  In the short term, we believe this will have a negative impact on economic activity in the region and a modest effect on overall U.S. GDP.  Sandy’s timing is particularly unfortunate because roughly 33% of annual retail sales occur in the last 25% of the year.  Additionally, the storm will provide plenty of “noise” to distort economic data as the effects of Sandy and the cleanup are felt for many months to come.  Cataclysmic storms are destructive and cause much human and material loss.  However, history shows us that the post-storm cleanup and rebuilding efforts stimulate economic growth by infusing capital and increasing employment into the affected area.
The Barnyard Forecast
The Forecast is our proprietary model for predicting stock appreciation over the next 6-18 months. Since 1990, it has correctly predicted the direction of the market about 75% of the time. It receives its name from the acronym used to “score” the prospects for stocks: Economy + Inflation + Earnings + Interest Rates = Opportunity.  Each component receives a score between 0 and 2, depending upon whether or not it is deemed to be negative, neutral, or positive for stocks.  The Forecast currently scores 5 out of a possible 8 points, which is a favorable score for rising stock prices.  The current stimulative policies of the Federal Reserve are the primary drivers of the model’s positive forecast.  Whereas, the most recent flat corporate earnings pulled down the model’s score.
Positive Analysts’ Earnings Estimates for 2013
Looking forward to 2013, Wall Street analysts’ current estimates for earnings growth are nearly 10% higher than 2012.  Earnings growth above 7% would move the Barnyard Forecast to a perfect score of 8 points.  Historically, stocks have produced double digit returns when the model reaches that level.     
Stocks on Sale!
The price-to-earnings (P/E) ratio reveals how much investors are willing to pay for $1 of earnings.  The most recent reading from our proprietary “P/E Finder” model indicates that the price to earnings ratio of stocks should be near 17.  The P/E ratio is currently selling at 14.3 times earnings.  Multiplying the model’s predicted P/E of 17 times the analysts’ 2012 earnings estimates of $105 suggests a year-end value for the S&P 500 of over 1700.  That is nearly 20% higher than the current level of about 1400.  In addition, our “Dividend Valuation Model” currently estimates that stocks are 15-20% undervalued based on the historical relationship between dividends and price.  We feel this confirmation of two separate models measuring two different indicators both arriving at the same conclusion is convincing evidence that stocks are, indeed, undervalued. 
Why are stocks trading so cheap?  The answer in two words is “risk premium.”  Our “P/E Finder” model is based on the relationship between P/E and inflation.  Historically P/E ratio has moved inversely with inflation.  Investors are worried that the Fed’s aggressive monetary policies will push inflation significantly higher.  We believe inflation may move modestly higher, but will not exceed 3% for an extended period of time.  In our judgment, inflation would have to stay above 3% for more than a year for P/Es to meaningfully fall.  With this in mind, in the absence of unforeseen shocks to the economy, we remain optimistic about 2013 stock performance.    
Fiscal Cliff
The media are full of worrisome stories about the repercussions of a continued stalemate between the Republicans and Democrats on a wide range of fiscal issues.  The so-called “Fiscal Cliff” is a combination of the expiration of the Bush-era tax cuts along with across-the-board cuts in defense spending and entitlements.  The consensus of the Wall Street experts we follow is that the ramifications of not solving these issues are unacceptable to both sides and that an agreement will be reached either before the deadline or shortly after the new Congress takes office on January 3rd.  The stakes are just too high for Republicans and Democrats to do nothing.  
The Elections
On balance, we believe the stock market would do better under Mitt Romney than under President Obama, who’s anti-business, anti-rich rhetoric has not endeared him to the business community.  Having said this, investors will be relieved just to have the uncertainties surrounding tax laws and the state of the U.S. budget cleared up one way or the other.  The only thing that would derail our positive view for the stocks would be if President Obama makes further attempts to expand the role of government at the expense of the business community or if earnings disappoint.  
As will be familiar to many readers, we rely on our models more than we rely on the hot news of the day.  Eventually stock prices follow value.  We believe stocks are already undervalued and will become more so in the year to come.  In this environment the path of least resistance for stocks is up.