History and Fundamentals Point to a Mildly Positive Year for Equities, by Sam Stovall of S&P Capital IQ

We see 2016 being a good year for the U.S. equity markets, but not a great one (or a flat one). Below are the historical , economic, and fundamental considerations contributing to this outlook.

Historical Perspective

·         A good year usually follows a flat one: Since WWII, there have been 10 times that the S&P 500 rose or fell by less than 3% in any calendar year. In the subsequent year, it gained an average 12.8% and rose in price 80% of the time. Only in 1947-48 was one flat year followed by another flat year.

·         Election-year results are usually solid: The S&P 500 gained an average 6.1% during the fourth year of the presidential cycle since 1948, and rose in price 76% of the time. In addition, small-cap stocks gained in price an average 10.9% and rose in 78% of all election years since 1980.

Economic Outlook

·         We see the sub-3% GDP growth trend remaining: GDP should grow 2.7% in 2016, and remain below 3% through the end of the decade. Growth in 2016 should benefit from a 3.1% rise in consumer spending, a 5.2% gain in capital expenditures, and a 7.5% jump in residential construction. Global GDP growth is also projected to be below par.

·         Fed funds will rise to 1.25% by the end of 2016: The FOMC will likely start tightening rates in December 2015, with additional rate hikes quarterly, depending on the data.

·         Oil prices will stop falling, but the dollar should firm: Oil prices should average $50/barrel, but the U.S. dollar will continue to rise on a trade-weighted basis.

Fundamental Projections

·         The S&P 500 should post 8% EPS growth: Capital IQ aggregate estimates see S&P 500 EPS rising to $126.44 by year-end 2016, with gains in all sectors but energy.

·         The EPS recession won’t morph into an economic downturn: Even though most EPS recessions since WWII were accompanied or preceded by U.S. economic recessions, we don’t see the projected 2015E EPS decline foreshadowing an economic downturn, due to a “V-shaped” recovery in quarterly earnings anticipated for 2016.

·         Rich valuations are supported by low inflation: At 23X, the S&P 500’s P/E on trailing GAAP EPS is 4% above the average since 1958 when core CPI was below 2.4%.

·         S&P 500 12-month target of 2250: We see the S&P 500 rising to 2250 by the end of 2016, based on an 8.0% rise in EPS and still-moderate inflation, though the prospects for higher rates should restrain P/E multiple expansion.

·         We favor the consumer discretionary, health care and telecom sectors: We are also underweighting energy, materials and utilities, due to higher rates and dollar forecasts.

·         Foreign equities offer similar growth estimates but lower valuations: Foreign developed, emerging and small-cap markets trade at discounts relative to U.S. markets.

So, there you have it. We believe equities remain the asset class of choice. We therefore recommend that investors maintain the equity exposure that is appropriate for their time horizon and risk tolerance, but advise them not to go too far out on the risk curve. This bull market is long in the tooth. At more than 6-1/2 years old, versus an average of 4-1/2 years since WWII, it may be held back by rising rates, below-par GDP and EPS growth, and elevated valuations. We don’t see a global recession on the horizon, and we prefer U.S. equities to international ones. The prospect of gradually rising rates in 2016 leaves investors with few attractive investment alternatives to equities. We suggest underweighting, but not avoiding bonds, the only negatively correlated asset to stocks. In all, we label ourselves “bulls,” but emphasize a lower case “B”.

Sam Stovall, U.S. Equity Strategist. S&P Capital IQ + SNL, New York, NY 10041