A year ago, we projected the S&P 500 would hit 3,100 at the end of 2019. Despite the swoon in equities in the fourth quarter of last year, we didn’t see a recession coming and our model for estimating fair value for the stock market was screaming, “BUY!”
At midyear, seeing the economic and trade-policy stars aligning for further growth, and with our model for equities (more on that below) still showing room for gains, we lifted our year-end forecast to 3,250. At a Friday (12/13) close of 3,169, we were only 2.6% below that level with 16 days to go.
For 2020, we remain bullish. Our call is for the S&P 500 to end the year at 3,650, which is about 15% higher than it finished on Friday, with the Dow Jones Industrial Average moving up to 32,500.
The first consideration we make when forecasting the stock market is whether we see a near-term recession. This step is important because even if the stock market is undervalued relative to long-term norms, a recession would almost certainly send equities lower in the short term; stocks would go from undervalued to more undervalued.
Needless to say, we don’t see a recession anytime soon. The economy is still adapting to lower tax rates and monetary policy remains loose. In addition, homebuilders are still generating too few homes given our population growth and scrappage rates, while banks are sitting on ample capital.
The second step, and usually the most important one, is to use our Capitalized Profits Model. The model takes the government’s measure of profits from the GDP reports, divided by interest rates, to measure fair value for stocks. Our traditional measure, using a current 10-year Treasury yield of 1.85%, suggests the S&P 500 is grossly undervalued.
However, we think long-term interest rates are headed higher, and this change can have a large effect on the model’s assessment of fair value. We anticipate that the 10-year Treasury yield will finish the year at 2.5%. Using 2.5% (instead of 1.85%) suggests an S&P fair value of 3,775. In other words, we should finish 2020 with more room for the bull market to keep running.
In addition, it’s important to notice that in recent years operating profits generated by the companies in the S&P 500 have risen much more than the government’s measure of corporate profits that we use in our model. In the prior business cycle, the one that ended in the Great Recession, profits peaked in the second quarter of 2007. Since then, S&P operating profits are up 55%, while the GDP measure of profits is up only 31%. This divergence suggests using the GDP measure of profits in our models may be underestimating the fair value of equities.
The biggest risk to our forecast is that someone on the far left wins the White House in 2020 and the Democrats simultaneously get a majority in the U.S. Senate. We think that’s very unlikely. Most likely, the outcome of the election ensures that the tax cuts remain in place without any radical new government “entitlement programs” or expansions of those already in place.
Like we said last year, this will probably be one of the most optimistic forecasts you’ll see, if not the most optimistic one of all. But, in the end, we do best by our readers when we tell them exactly what we think is going to happen, without altering our projections so we can run with the safety of the herd.
Last year we told investors to “grit your teeth” because “those who stay invested in the year ahead should earn substantial rewards.”
Our advice remains the same. The bull market is not yet done.
The opinions expressed in this article are those of the author and do not necessarily represent the views of Proactive Advisor Magazine. These opinions are presented for educational purposes only.
This is an edited version of an article first appearing at www.ftportfolios.com. This report was prepared by First Trust Advisors LP and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
First Trust Portfolios LP and its affiliate First Trust Advisors LP (collectively “First Trust”) were established in 1991 with a mission to offer trusted investment products and advisory services. The firms provide a variety of innovative financial solutions, including UITs, ETFs, CEFs, SMAs, and portfolios for variable annuities and mutual funds. www.ftportfolios.com
