With the S&P 500 rapidly running away from the 2,300 bogey, which has been the year-end price target for most sellside strategists, analysts on Wall Street had two choices: either urge their clients to sell, or raise their target. Overnight, Bank of America’s Savita Subramanyan became the first in recent weeks to throw in the cautionary towel, and raised the bank’s year-end S&P price target from 2,300 to 2,450 to “reflect an increasing likelihood that we are entering the typical later stages of a bull market, during which fundamentals typically take a back seat to sentiment and technicals.”
Nonetheless, she does attempt to and adds that “typically, in the later stages of a bull market, corporate earnings are cyclically elevated and the multiple that the market assigns to those earnings is often elevated as well. As a result, market prices can become significantly overvalued relative to their intrinsic fair value, and this divergence can last for years. Thus, we would highlight the distinction between our year-end target of 2450 (driven largely by sentiment and technicals) and our estimated intrinsic fair value of 2230.”
In any event, it is clear that to avoid a client rebellion, BofA had no choice but to go with the number that is driven by “sentiment and technicals” and not with what makes fundamental sense.
Here is Subramanyan’s justification for giving up on her existing outlook, and joining the “animal spirits” parade:
Raising 2017 S&P 500 year-end target to 2450
We are raising our 2017 year-end S&P 500 target to 2450 (from 2300), driven by two changes: (1) we lower our end-of-year equity risk premium (ERP) assumption to 400bp (from 450bp), and (2) within our five-factor framework, we adjust our fair value model weight lower in favor of our sentiment model. These changes reflect an increasing likelihood that we are entering the typical later stages of a bull market, during which fundamentals typically take a back seat to sentiment and technicals. We think the market still has the potential to move higher as investors capitulate into equities; note that the “Great Rotation” out of fixed income into equities has yet to happen. But as we noted in our Year Ahead, we see a wide range for 2017, and investors are likely better served focusing on the internals of the market rather than on a year-end number. And for longer-term investors, elevated valuations and high leverage today shift the risk-reward balance for the market to more risks than were evident a few years ago.
The stock market has always seen outsized returns leading up to its eventual crash, and we think this time will be no exception. In addition to lowering our end-ofyear equity risk premium (ERP) assumption to 400bp (from 450bp), we are adjusting our fair value model weight lower in favor of our key sentiment model. As a result, we are raising our 2017 year-end S&P 500 target to 2450 (from 2300), which implies a better than 75% probability weighting of our 2700 bull case scenario and less than a 25% probability weighting of our 1600 bear case scenario.
Focus on the risk-reward balance instead of the target
But there is a wide and binary range of outcomes, and we think investors are better served thinking about the risk-reward of stocks rather than an absolute target. Elevated valuations and high leverage today shift the risk-reward balance for the market to less, rather than more, attractive for investors with medium- or longer-term time horizons.
We expect the market to overshoot its fair value
Typically, in the later stages of a bull market, corporate earnings are cyclically elevated and the multiple that the market assigns to those earnings is often elevated as well. As a result, market prices can become significantly overvalued relative to their intrinsic fair value, and this divergence can last for years. Thus, we would highlight the distinction between our year-end target of 2450 (driven largely by sentiment and technicals) and our estimated intrinsic fair value of 2230. For investors with long time horizons, our long-term (year 2025) target of 3500, which is based solely on valuation, indicates a solid but below-average annual price return of 4-5% (or total return of 6-7%).
Equity risk premium has moved quickly, likely to undershoot
The combination of improving investor sentiment, accelerating global growth and hopes for stimulus (i.e. the “Trump Put”) is driving the market to new highs and compressing the ERP faster than we had assumed. The normalized ERP has fallen to post-crisis lows and is less than 100bp from the 30-year average (excluding the Tech Bubble), and seems to be in the process of undershooting as it typically does at the end of bull markets. Our fair value model currently assumes that any further ERP compression will be offset by rising normalized interest rates, and thus, no further expansion of the normalized PE.
Watch out for volatility when the “Trump put” expires
We would expect the rally in lower quality stocks to fade as we get more clarity / details of potential stimulus and tax reform, where expectations today are quite optimistic relative to the likelihood of delays, friction and more negative offsets than the market is currently pricing in. Meanwhile, economic surprises are close to a five-year high and we expect S&P 500 earnings growth to decelerate in the second quarter. While we see further room for market sentiment to improve, the market may take some time to digest the recent surge in optimism before heading higher. So while we expect stocks to end the year higher than where they are today, the road could get bumpy as we head into spring and summer months. As such, we see an elevated probability that the market falls below our 2230 fair value estimate before the end of the year.
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via http://ift.tt/2mEphQQ Tyler Durden