Winter Letter To Clients {Part II}

The S&P 500, the broadest measure of the US stock market, currently trades at 16 times earnings.  This is elevated in terms of price but by itself not fatal for market advances.  Stocks have historically traded in a price to earnings valuation range between 14-16 times their forward estimated earnings.  Also there is considerable debate on where equities ought to trade in a low interest rate world.  However, very few will argue that stocks are in the aggregate cheap. In regards to the current economic environment, we think that investors will have to once again get used to a higher level of volatility.  However, based on current analysis we think markets also have the potential to also be higher by year-end.  Here’s why.

We are using an estimated earnings range on the S&P 500 of 123-128 with a mid-point of 125.50 for this year.  Our current 2015 price cone of probability is 1,750 to 2,250 on the S&P 500.  That is appreciation potential of roughly 4-10% when accounting for dividends.  We introduce a preliminary estimate of 2016 earnings ranging between 130.50-135 for the S&P 500.  Please note that there is no guarantee that any of these estimates will be met.  The Cone of Probability is our current assessment of the price range within which we think stocks have the potential to trade during a described period, in this case calendar year 2015.  It is a probabilistic assessment based on many inputs.  Some of these are: earnings estimates, and whether those estimates are rising or falling, dividend yield, earnings yield and the current yield on the US 10 year treasury.   We use this solely for analytical purposes.  It will fluctuate with market conditions and changes to the data inputs.  Index prices can and have traded in the past outside of its range.

At first glance with stocks struggling out of the gate, it might be hard to make an argument for higher prices in 2015.  Indeed it would not surprise us if our “friend” volatility wrecked a bit of havoc on equities this year.  It is now greater than two years since the markets have experienced a correction in excess of 10%.  This possibility means we have the defensive pages of the playbook and game plan nearby. But irrespective of these concerns we hold to our basic argument that things have been getting better in the US. The above-mentioned decline in the price of oil is the equivalent of a massive tax refund to the American consumer, one that is only now being felt in the economy. Unemployment is back to pre-recession levels, consumer confidence has returned which is manifest in record purchase of automobiles and a pick-up in housing. Markets like divided government.  A Democratic President contesting a Republican House and Senate is about as divided as it can get. There will be no sweeping agenda out of Washington this year or next as the Presidential races open up.  We are still of the opinion which we have reiterated over and over these past few years that positive demographic trends, advances in productivity as rooted in the efficiencies of the knowledge based economy and the continuing age of innovation that we have dubbed the “era of miniaturization” are all longer term positives for the economy. 

One major wild card is in the international arena.  The recent tragic events in France show that terrorists still have the potential to wreck havoc on Western society.  Also the Middle East and Ukraine are not going away this year.  Yet these events have in many ways been with us for the past decade and markets have learned to live with these events, horrible as they are.  At some point markets will have to deal with a deteriorating economy.  The evidence so far does not seem to indicate that 2015 is going to be that year, particularly in regards to the United States.

Tomorrow: The conclusion to our letter.

**Long ETFs related to the S&P 500 in client and personal accounts.