The market is coming off the best September in over 70 years. It’s tempting to get caught up in the emotion of the big rally and go whole-hog long. However, fears of a double-dip recession are by no means forgotten.
That is the current puzzle that faces investors. Should they climb on board the stock market rally hoping for greater gains? Or take profits now? Let’s review the landscape to figure it out.
Bullish Case
The best case for the market to continue higher is based upon the earnings outlook. The current earnings estimates for the S&P 500 are about $94 for next year. That is only a P/E of 12.1, which is historically below average. One could easily see that climb to 14 without any fear of being overvalued.
Now consider the earnings yield of the market versus the risk free rate in the 10-year Treasury (actually it’s almost comical to call it the “risk-free rate” given how much debt we have on the books. But that is a story for another day). The earnings yield on the S&P 500 stands at 8.2%. That is an incredibly attractive return versus the 2.6% for the 10-year Treasury.
Yes, there are other reasons to be bullish, but none are stronger than these two. So let’s leave it at that for now.
Bearish Case
Clearly the economic recovery is not as strong as expected at this stage, with the most recent quarterly GDP coming in at only +1.7% growth. The majority of the recent economic data is either showing a leveling off of activity or a modest decline.
Many economist point out that this is a classic “soft patch” in the midst of a normal recovery. Unfortunately, economists have a terrible track record of predicting changes in direction for the economy. As Ross Perot once said, “If economist are so smart, then why aren’t they richer?” So the fear is that this soft patch devolves into a double-dip recession.
As for the earnings estimates for next year, they are created by sell-side analysts. Unfortunately, they too have a bad track record of predicting the major turns in direction for the earnings outlook. Meaning they rarely raise estimates before a new era of economic growth. And they rarely lower them before a new recession kicks in.
So the best case for the bears is that the case for the bulls is made by folks with poor track records. And simply given the depths of the mess we are trying to climb out of, you can see why the bearish/double-dip economic scenario has to be given some credence.
Muddle-Through Case
Between the Bull and Bear scenarios is the Muddle-Through case. Meaning a period of slow growth for the economy and corporate earnings. But growth nonetheless.
Here the stock market meanders around in a trading range, maybe going up about 5% a year on average. Not gangbuster returns, but a heck of a lot better than holding any cash instruments.
It’s no shock to anyone that I find myself in this camp. And to be in this camp also means that I think the $94 per share earnings estimate for the S&P market is a shade too high. Perhaps $85 – $90 is more like it. Given that reasonable P/E of 14 = a potential outcome of 1190 to 1260. About 5 to 10% above current levels.
That says to lean towards a higher allocation in stocks. I wouldn’t go too aggressive on the picks because if growth estimates do slow, then the more aggressive stocks will take more of a beating. That calls for a blended portfolio with a healthy serving of large caps with high dividends — many of which are paying as much if not more than the 10-year Treasury. Then you can have a handful of select growth stocks to try and generate outsized returns.
The key here is to be mindful that the market may turn at any time. That turn may be for the better if earnings really do come in more like $94 or greater for S&P 500. Yet it may also turn for the worse. So put your strategy in place for now. Just be ready to change that strategy as the preponderance of the evidence dictates.
Zacks Investment Research
