Sunday, January 03, 2016

I predict the S&P 500 will end 2016 at 2,336, up about 14% from its year end 2015 figure of 2,044

Cliff notes

I predict that the S&P 500 will end 2016 at 2,336.  This represents a 14.3% increase above the year end 2015 figure of 2,044.  Barring a black swan event, I think the risks to this forecast are slightly to the upside; that is I think we could see the S&P above 2,400.  Note that the current all time high for the S&P 500 is 2,134, so I am predicting a series of fresh all time highs.

I would likely predict about the same 14% increase for the Dow Jones.  It closed 2015 at 17,425, so I would predict it ends 2015 at about 19,865.  Obviously 20,000 would be very much achievable if my forecast is right.

I note that I have been bullish on the market for a LONG time, and remain so.  More on that in an upcoming blog post.

I arrive at my prediction of 2,336 for the S&P 500 by assuming about a 14% increase in earnings for the 500 ish companies in the index, while keeping the price to earnings multiple the same. .

I expect the US economy to grow about 2.5%, just slightly above the very boring 2%+ range it has been in for much of the recovery.  (I must note here that I have been noticeably too optimistic about US GDP growth for years).  I expect interest rates to rise gently (perhaps 50 basis points on the 10-year treasury bond).  I expect inflation to pick up once oil bottoms, but not in a fashion that will scare the Fed or the market.  I expect the fed to raise interest rates only 2 or 3 times in 2016, as a still sluggish economy, and slightly slowing job growth mean that a real inflation scare is very unlikely.

I arrive at my 2016 Price Target by Estimating S&P 500 earnings and estimating a Price to Earnings Multiple

One way to value a stock or a market is by the age-old price to earnings ratio.  If a stock trades at $10/share, and earns $1/share, it has a Price to Earnings ratio (P/E) of 10 (and is often considered cheap).  The same valuation methods work for the S&P 500.  However, this is not a simple process.  First, you need to predict the earnings, or the E.  This is tricky enough, and estimates 12 months ahead are often well off the mark (typically too optimistic).  Next comes the harder part. You must assign a multiple.  Simplistically, if a market (or a stock) trades at a low multiple, say 10, that means the market is pessimistic on future earnings growth for that company.  Interest rates also play a large (and in my opinion hugely under appreciated) part in assigning an appropriate multiple.  Low interest rates should and typically do mean high P/E multiples, and high interest rates mean low multiples.

Thus in order to arrive at a price target for the S&P 500 by this methodology, I need to (a) estimate earnings for the S&P 500 in 2016; (b) estimate the Price to Earnings multiple at year end 2016; and (c) multiply the earnings by the multiple.  The result of that multiplication is my price target.  Is this a valid exercise?  Yes, I think so.  There are a series of assumptions that go into my estimate of the "appropriate" multiple, and disagreement with these can easily yield strong disagreement on the multiple I assign, and a wildly different price target.  I don't mean to make this sound scientific.  But I humbly submit there is some science involved.

S&P EPS 2015

Earnings per share for the S&P 500 for 2015 were about $105/share.  That is the number I am using.  (Its impossible to know exactly as final results are not in yet and I found significantly different numbers in a few places, some lower, some much higher.  

Raymond James said just a few weeks ago that 2015 earnings were $107.   

Standard & Poors' spreadsheet, with some extrapolation, yielded $105, so that's what I'm going with.   (additional Info, Index earnings).

I note that as for the obvious question what does S&P 500 earnings per share mean, the issue is quite complex. There is no one company, obviously. Instead, its a formula, based on the earnings of the constituents of the S&P 500, multiplied by the company's weight in the index.  Thus Apple's earnings count for more than General Electric, as Apple's market capitalization is nearly double GE's.  And so on, with smaller companies counting for less.  Honestly, I don't really understand the formula, except in broad outline.  Happily, I don't have to.  By relying upon published actual and estimated earnings per share and using the closing price of the index, I can easily compute the price to earnings multiple (as many do) and go from there.  I don't really need to understand precisely how it is computed.  

S&P 500 Price to Earnings Ratio for 2015.

The S&P ended 2015 at 2044 (rounded to the nearest whole point).  Thus the Price to Earnings ratio at year end 2015 was 19.47 (2044/105 = 19.47).  I use this P/E ratio to come up with my 2016 target for the S&P 500.  I assume no change in the multiple at all.  While this is obviously very unlikely to occur precisely, it does mean that I am not relying on any expansion of exuberance on Wall Street.  

S&P P/E recent history

19.47 is a fairly high P/E ratio historically, but not wildly so.  the ratio was MUCH higher during the wild bull market of the late 1990s, when I think nearly everyone agrees the market was significantly overvalued.

I think 19.47 is slightly below where the P/E ratio should be, given that inflation is VERY low, interest rates on long term government treasuries (key competition for bonds) were VERY low compared to history, and earnings growth potential for the next few years was/is good.  Obviously, one can disagree with these key assumptions.

One way to look at this is what is called the earnings yield.  This is merely the inverse of the Price to earnings ratio.  If the P/E ratio is 20 (close enough to the actual 19.47 for this big picture point) that meanings the Earnings yield of the S&P 500 (earnings/price) is 5%.  Put another way, stocks are "earning" 5%.  $105/share in earnings is just under 5% of the 2,044 that the S&P ended the year.  That's a pretty good deal in comparison with the 10 year treasury bond, which closed the year at 2.27%.

Predictions for S&P 2016 Earnings Per Share 

I am "estimating" 2016 earnings to be $120/share, a number I believe to be slightly conservative.  When I say I am estimating, what I really mean is that that is the number I am ASSUMING.  I lack the capacity (by a long shot) to actually run bottom up estimates for what each of the 500 (ish) companies in the S&P 500 index will earn and then multiply each appropriately.  Instead, I am relying upon estimates by the big banks.

RBC (Royal Bank of Canada) predicts S&P earnings for 2016 of $124/share (recently cut from an earlier $128).

Raymond James predicts $126/share.

Goldman Sachs in late September predicted $120/share for 2016:

Barrons states that the mean average Wall Street estimates for 2016 are $123.50, with most estimates being higher.

I am assuming $120/share.  $120 represents about a 14% increase in earnings over 2015.  A 14% increase in earnings may seem very optimistic, but is in line with earnings estimates by Wall Street, above, (which I freely admit are almost always too high).  I think this time the estimates are slightly too LOW because I expect the consumer to finally spend more of the savings resulting from massively lower oil prices, while the negative effects of lower oil should be largely played out.  If it sounds like I am saying this time is different, that's because I am.

By coincidence, the $120 estimate I am using for 2016 is exactly the same as Goldman's estimate.  I think the risk is to the upside; that we could actually end up between 125 & 130, as the more optimistic seers on Wall Street are predicting.  However, I have been too optimistic on economic growth (which tends to yield higher earnings) for a long time now, and its time to make a different mistake!

S&P predicted 2016 P/E and thus target price for 12/31/16

2016 earnings per share of $120 X the projected P/E ratio of 19.47 = my target of 2,336.

The final item necessary for me to come up with a price target for year end 2016 is to estimate the Price to Earnings multiple at the end of 2016.  This depends on my view of interest rates (gentle rise), inflation (rise), and my prediction for overall optimism of the market in general (about where it is now, or slightly more optimistic).

As I said above, I am using the P/E ratio from year end 2015, which was 19.47.  I think that forces pulling it higher are evenly balanced with forces pulling it lower.

Forces pulling the P/E higher include slightly better economic growth, a predicted encouraging rebound in earnings, better numbers out of Europe and possibly Japan, China failing to implode and slightly less pessimism about the US recovery.

Forces pulling the P/E lower include slightly higher interest rates, continued sluggish growth, potentially a further rise in the dollar (this would surely effect earnings, whereas the effect on the P/E multiple is not clear), and, most importantly, a rise in inflation, as we lap the sharp declines in oil prices.

Crucially, I am betting that Janet Yellen does not panic in the event inflation rises slightly as she and others predict, and raise short term interest rates quickly.  That is absolutely mission critical to everything written here.  If the economy performs as I expect, and Yellen raises rates 5 or 6 times, the market should be about flat for 2016 even if we do earn the $120/share on the S&P 500 that I am assuming.  The reason is that the market will take down the P/E ratio in a world of rapidly rising short term interest rates and a sluggish economy.  In contrast, if we see 3%-3.25% GDP growth, the market would happily accept 5 or 6 interest rate hikes.  This is a very unlikely scenario.

A final word about inflation.  Inflation should FINALLY move towards or even above the Fed target of 2%.  With the recent sharp price DECREASES coming off the books, and a predicted somewhat higher oil price for the year, the inflation in the rest of the economy (health care, education, rent, housing) becomes a larger weight in the CPI. See Bob Johnson of Morningstar.