Deutsche’s David Bianco “Forecasts” The S&P
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Via Deutsche Bank, We raise 2015 yearend S&P 500 fair value target 7.5% to 2150 from 2000
We still expect a long lasting economic expansion of moderate growth, which should rival the US record of 10 years with S&P EPS growth averaging 6% until the next recession, on 5% sales growth, flat margins, 1% share shrink. Despite entering the latter years of a typical expansion and high margins vs. history, we now think the trailing S&P PE should average 17 vs. 16 until elevated recession risk returns. This is because we now expect long-term real interest rates to stay below normal through 2016 and thus lower our S&P 500 real cost of equity estimate from 6.0% to 5.5%. We raise 2014 and 2015 yearend S&P targets to 2050 and 2150 from 1850 and 2000 and introduce 2300 for 2016 yearend.
PEs can stay above normal if long-term real interest rates stay below normal
Good reasons exist for decent EPS growth and yet subnormal interest rates, which justifies trailing PE of 17 or higher. Although a 17 PE exceeds the trailing PE average of 16 since 1960, it is lower than the last 20 year average of 18.5. While long-term real EPS growth will likely lag the 5% average since 1994, real interest rates are likely to be lower. Assigning a higher PE based on lower real interest rates, makes it important that inflation risk stays dormant to prevent long-term rates from returning to historical norms. Despite the DCF math of lower rates justifying higher PEs, investors are likely to be skeptical of sustaining both decent EPS growth and subnormal interest rates, causing the index to advance only in-line with EPS growth next year as a correction is more likely on any growth or inflation scare if the trailing PE pushes above 18.
2014 S&P target – 2050, 17 PE: 1) 2015-2016E EPS growth >5% and DPS growth >10%, 2) Fed stops purchases and 10yr Tsy yield <3% at 2014 end, 3) Midterm elections result in a small Republican majority in Senate.
2015 S&P target – 2150, 17 PE: 1) EPS growth outlook stays >5%, 2) Fed hikes slowly, 10yr Tsy yield <3.5%, 10yr TIPS 0.5-1.5%, 3) oil >$90/bbl. 4) strong Banks DPS growth upon less litigation, manageable capital rules.
2016 S&P target – 2300 (+/- 100), 16-18 PE if: 1) Still no recession on the horizon, 2) Fed rate hikes stop 2-3% on low inflation despite good growth, 10yr Tsy Yield <4%, TIPS yld ~1.5%. 3) lower repatriation taxes to sustain strong DPS growth. If inflation stays low as growth persists, allowing an extended pause in overnight rate hikes this could sustain an 18 PE. However, if hikes continue above 3% the PE is likely to decline toward 16.
We expect ~6% EPS growth in 2015-2016 and ~15% DPS growth as payout nears 40% of EPS. Our 2014E, 2015E and 2016E EPS are $119, $126 and $134.
Recession and Bear market still distant, but dips and correction risk significant
Uptick in the US labor force participation in July and a weaker Europe deferred the interest rate risk we feared this summer and caused S&P to exceed 2000. However, stocks have yet to confront 10yr Tsy yields >3%, which we think is likely next year, and will test the ability of PEs to stay above average. This expansion should be long lasting, as it took longer than usual to gain momentum, inventories and capex remain measured, home building has upside, loan growth is better but still subnormal and both bank and household balance sheets are stronger. But lower oil prices threaten S&P EPS, especially if China slows. Weak oil hits Energy earnings and capex, which hits Industrials.
The S&P 500 can probably reach 2500 before suffering a 20%+ bear market decline
The two major threats to the S&P 500 are either a recession or a rapid increase in interest rates. However, assuming that the US avoids a recession – and no other global factor causes a significant decline in S&P EPS – and that US interest rates climb slowly and rise to a level that plateaus below historical norms, then 2500 is within reach for the S&P 500 by 2018. The risk of a correction will climb as investors take concern with the longevity of the expansion and the risk of tightening monetary policy, which likely curbs the PE and price gains especially in 2016-2018. Dips are likely along the way and probably at least one correction upon a global growth or inflation/ interest rate scare.
While we see 2500 as a reasonable fair value for 2018 end, either a correction in the next couple of years or a bear market even if several years from now could put the S&P 500 back under 2000. As a bear market triggered by a recession, in which S&P EPS declines 20% on average from 4-quarter peak to trough and forward PEs tend to fall below average until the economy and EPS stabilize (then PEs rise above average) could erase all further cycle gains. Thus, it’s unlikely the S&P stays above 2000 through the rest of this cycle into the next unless EPS growth gets stronger or the cycle is very long.
A recession triggered by problematic inflation causing interest rates to climb above normal is the worst threat to retaining further S&P 500 gains we anticipate from this cycle as both EPS and the PE would suffer. This risk appears low at this time, but this is a long-term risk and long-term outlooks are very uncertain. At this time, we are more focused on data that confirms the likely longevity of the expansion to stay constructive.
In summary – assuming nothing bad happens and assuming the same linear trend happens for another 4 years, the S&P 500 can rally to 2500 with no meaningful drops… oh ok then!
