Barron’s is out with its always interesting “back to school” early September survey of Wall Street strategists, hailing from both the buy side and sell side. Though the samples size of nine is a bit small (where are Deutsche, U BS, Credit Suisse & JPM?) it is a useful compendium of apples-to-apples figures on what strategists are telling clients.
The take of Barron’s writers on the results is that strategists are bullish, and I don’t disagree. However, if we actually scrutinize their numbers, the strategists are saying we won’t get further stock price gains this year—even though the fourth quarters of mid-term election years tend to be strong. Their average year-end 2014 price target for the S&P 500 is 2011, virtually even with the current level. Only two of the nine houses look for material gains from here (in both cases, up 5% to 2100).
Here are the raw numbers. (I use averages for the nine strategists; median figures are virtually the same.)
2014 year-end price target for S&P 500 2011
2014 S&P 500 EPS 117.5
2015 S&P 500 EPS 126.8
2014 year-end trailing PE 17.1
2014 year-end forward PE 15.9
2015 S&P 500 EPS growth 7.9%
The “Fair PE” Rises 20% in Two Years(?!)
The strategists’ idea of what is a “reasonable PE ratio” has increased a lot in two years. In early September 2012, their 2012 year-end target implied a trailing PE of 13.8x (versus 17.1x now) and a forward PE of 13.2x (versus 15.0x now). So, the strategists are using PE targets that are 20% higher than two years ago.
This is not at all surprising to me. I pointed out two years ago that “Wall Street’s strategists are using PE assumptions that are very conservative by historical standards, particularly considering that we are in a low-inflation, low-interest rate environment.” (Emphasis in original.) I argued that “Muted Expectations Could Set the Stage for a Positive Stock Market Surprise,” which was the title of my September 2012 post. (Admittedly, I was right partly for the wrong reason; I suggested a Romney Ryan victory would trigger an upward “re-rating” of equities.)
S&P 500 at 2170 Sixteen Months from Now?
If we apply the strategists’ now rather lofty PE assumptions to their 2015 EPS figures, they are looking for a 2015 year-end price target of 2170 (17.1*126.8).
Their earnings forecasts look reasonable. The 117.5 for 2014 looks a little low, but the 7.9% growth expected for next year is fairly bullish, given elevated profit margins, mounting wage pressure in some industries, higher stock prices that mute the benefit of buy-backs, a recessionary Europe and a strong dollar that creates currency translation headwinds and reduces energy prices. (Lower oil prices are negative for profits, because revenue is transferred from oil companies to consumers.)
Bullish Consensus Creates Potential for Negative Surprise
What I see in these numbers is a disturbingly bullish consensus, based on high PE assumptions and upbeat earnings expectations. I don’t disagree with the strategists’ assumptions; I have been saying for quite a while that stock prices would “grind higher.”
Nevertheless, in terms of “positioning” and investor psychology, we are vulnerable to negative news. In contrast to two years ago, when PE ratios were much lower, stock prices could fall pretty sharply on a nasty surprise—perhaps a terrorist attack or a political / financial spasm in Europe. When investors are bullish and valuations are high, stock prices don’t necessarily need a good reason to tumble. Investors have big profits to protect. In the first half of 1962 stocks dropped more than 23%, even though earnings rose 15% that year and the U.S. was in the midst of one of the most prosperous five-year periods in its history, comparable to the early 1830s, the late 1860s, 1898-1903 or the late 1990s. The catalyst for that drop was a confrontation between President Kennedy and U.S. Steel over steel price increases.
Investment implication: This is not the time to be particularly aggressive in the stock market. Unlike two years ago, lots of good news is priced in, and there is a decent chance the next big surprise is negative.
Copyright Thomas Doerflinger 2014. All Rights Reserved.