How High Stocks Can Go From Here


July 12, 2016, 2:00pm EST

As we said last week (and back in May), we think the second half of the year will be big for stocks.

Contrary to popular opinion, the world is not falling apart. In fact, the ratcheting down of expectations has set the table for positive economic surprises, which is powerful fuel for stocks.

Consider this:  If you awoke today from a decade-long slumber, and we told you that unemployment was under 5%, inflation was low, gas was $2.15, mortgage rates were 3.5%, you could finance a new car for 2% and the stock market was at record highs, you would probably tell us the outlook for the economy looks really, really good.

Those are the conditions we have, yet most think the sky is falling.

As we’ve discussed, the central banks are in control, and they have been since the depths of the financial crisis.  Say what you will, but they have (led by the Fed) orchestrated a global economy recovery (albeit much slower than typical post-recession recoveries) and have produced and preserved economic stability along the way.  Playing a key role, in the face of intense scrutiny from the “run-away inflation” theorists, they have pinned down interest rates which have warded off a deflationary spiral and created the framework of incentives to hire, spend and invest.

With the above said, we think we could be on the precipice (if not the early stages) of an economic boom.

As for stocks, within that context, today we want to revisit some of our previous analysis on where stocks can go from here…

1) History
The long-run annualized return for the S&P 500 is 8%. If we applied that number to the pre-crisis highs from 2007 of 1,576 on the S&P 500, we get 3,150 by the end of this year. That’s 47% higher than current levels. That’s what it would take to make up for the nine years that stocks have been knocked off path — just to simply get the S&P back in line with historical norms.

2) Valuation
In addition to the above, consider this: The P/E on next year’s S&P 500 earnings estimate is just 16.9, near the long-term average (16). But we are in a very low interest rate environment. In fact, we are in the mother of all low-interest-rate environments (still near ZERO). With that, when the 10-year yield runs on the low side (it’s very low), historically, the P/E on the S&P 500 runs closer to 20, if not north of it.

If we multiply next year’s consensus earnings estimate for the S&P 500 of $126.76 by 20 (where stocks to be valued in low rate environments), we get 2,535 for the S&P 500 by next year — 18% higher.

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