Why the S&P 500 Topping 1,700 Is More Likely Than You Think

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[dropcap]T[/dropcap]here’s plenty of chatter surrounding the S&P 500’s +25% run since last October (through 3/9). A small group say the rally has only just begun, but for the vast majority there’s a growing fear of heights. Or maybe a sense of caution is a better description. Either way, equities have posted solid returns over the last few months, and that can shake our nerves, particularly following a nasty market correction. Should I sell? Did I miss the rally? Should I wait for a pullback before buying? I’ve heard all these questions in recent weeks. There are plenty of risks out there, but there are also positives. So now is probably a good time to take the market’s temperature and see what’s possible in 2012.

Beginning of Year Expectations

Determining market expectations can provide valuable insight into the future. Said another way, if every market strategist and analyst predicted stocks to fall 40%, it likely wouldn’t come true. That dour sentiment would get priced into the market, making upside surprises more likely (kind of hard to get much worse than a doomsday scenario). This would help support equity prices making a smaller down move, or even a positive up move, more probable.

So what were expectations at the beginning of the year? In December, Business Insider aggregated S&P 500 forecasts from strategists at multiple prominent investment firms. The list included Goldman Sachs, JP Morgan, Citigroup, Barclays, Deutsche Bank, and Morgan Stanley, among others. Out of this group, the average 2012 forecast for the S&P 500 was 1,363 at year end, with a range of 1,167 to 1500. This translates into an up move of 8.4%, with a low end of -7.2% and high end of 19.3%. Clearly expectations are for a positive year, but no one is really expecting a big positive year. Only two forecasts were even above 15%. The majority of strategists emphasized “caution” in their outlooks, with European fallout as the greatest potential risk.

Will the Past Become the Future?

Let’s first consider precedence. History shows that an 8.4% return for the S&P 500 is relatively modest. This statement may seem odd. After all, everyone knows the average annual return for stocks is around 9% to 10%. So 8.4% would seem normal, right? Figure 1 is a histogram of annual returns for the S&P 500 since 1926. As it shows, only 14 of the 87 annual returns fell between -0.1% and +10.7%. In other words, modest single digit up years only occurred 16% of the time. The vast majority of returns, 55% to be precise, fell above +10.7% with over a third of all returns above +21.5%. So while 8.4% might seem like a normal year, in reality it’s quite abnormal. Large double digit returns are much more common.

It’s also a presidential election year. Going back to 1926, the S&P 500 has generated negative returns in only four of twenty-one such occurrences. The largest was in 2008 as the financial crisis triggered a bear market and recession. Out of the positive years, twelve yielded double digit returns. The figures become even more positively skewed when presidents are reelected for second terms. Only one of eight such years was negative, and this was actually Franklin D. Roosevelt’s third term (I counted all reelections as a second term). Granted, these are small sample sizes. But perhaps there’s logic behind it? To the public, getting the same president for another four years means just that: more of the same. We all know markets hate uncertainty. I’m not claiming an Obama victory is imminent, but historically it’s proven very difficult to unseat incumbents. And if economic data remains positive, his chances will only improve.

Most likely outcome for 2012?

A modest up year is quite possible, but history suggests it’s not probable. The fact most forecasts are centered around such an outcome only increases the odds of something different occurring: perhaps a much larger up year or even a down year. Remember, surprises are what drive the market. These same strategists expected moderate economic growth with Europe as the major wild card. But over the last two months, many of these fears subsided—Greece secured its rescue package and successfully pulled off its debt swap. US economic data remains largely positive with improving employment and strong corporate earnings. All of this leads me to believe a down year scenario, or even a modest up year, is less likely.

So does the market’s run since October scare me? No. The speed of this rally does increase the odds of a market correction sometime soon. But corrections are temporary, and attempting to time them is a risky game. In my opinion, there are simply too many positive forces at work to be bearish. The US economy is proving too resilient, valuations are too attractive, and there is too much cash still on the sidelines. And if history repeats itself, we may be in store for larger returns than most expect.

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Brendan Erne, CFA
Brendan Erne serves as the Portfolio Management Team Leader with Personal Capital Advisors. He has over 15 years of industry experience, spanning almost all levels of the investment process, including several years at Fisher Investments as an equity analyst covering the Technology and Telecommunications sectors. He also co-managed a large cap growth portfolio and co-authored Fisher Investments on Technology, published by John Wiley & Sons. Brendan is a CFA charterholder.

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