Sticking to Our Targets, For Now

Late last year we shared our stock market forecast for 2022 (thanks again Brian Wesbury), projecting the S&P 500 would rise to 5,250. Since then, however, equities have dropped, with (now realized) fears about Russia invading Ukraine and the recognition that inflation is a more persistent problem than the Federal Reserve had previously let on, which means some combination of faster rate hikes or a higher ultimate peak for short-term interest rates, or both.

Reaching our year-end equity targets would now take a steeper climb than we previously planned: 20.7% for the S&P 500 from Friday’s close. But we still like those targets and don’t see enough reason to change them.

As we thought, Russia would likely invade Ukraine soon after the Olympics ended, but that this event is unlikely to change the long-term outlook for corporate profits. As a result, any drop in equities is a buying opportunity.

Sure, the Biden Administration might try to exert pressure on Russia through economic and financial sanctions. But other countries, like China and Germany, have strong interests in continuing to exchange freely with Russia. Ultimately, right or wrong, we think the Biden Administration is more concerned about managing its image involving the Russia-Ukraine conflict, for purposes of domestic politics (like, not “appearing weak”), than trying to alter the outcome of the conflict itself.

Meanwhile, and for the time being, inflation is likely to be equities’ friend, not their foe. Companies with pricing power, commodities’ companies, and materials’ firms, in particular, should do well. I had an interesting lunch conversationthis week with a wood products manufacturere who explained how they are doing really well and inflation was why.

In addition, the message from the First Trust Capitalized Profits Model hasn’t changed, at least not yet. Their cap profits model takes the government’s measure of profits from the GDP reports, discounted by the 10-year US Treasury note yield, to calculate fair value. Corporate profits for the third quarter were up 19.7% versus a year ago, up 21.2% versus the pre-COVID peak at the end of 2019, and at a record high.

The key question from First Trust is what discount rate to use? If they use 1.90%, roughly the current 10-year Treasury yield, their model suggests the S&P 500 is still grossly undervalued. But, with the Fed about to embark on a series of rate hikes and inflation likely to keep running higher, the 10-year yield is likely to keep rising, although not in a smooth linear way.

So, to be cautious, First Trust plugs in some alternative higher long-term interest rates. Using third quarter profits, it would take a 10-year yield of about 3.00% for the model to show that the stock market is currently trading at fair value. And that assumes no further growth in profits. With a 10-year yield of 2.50% all it would take is profits 3% above the level in Q3 for the model to estimate fair value at 5,250, which is what they projected for the end of 2022.

The bottom line is that change is happening fast in 2022: COVID is winding down, borders are in flux, and monetary policy is in for a major and long-overdue shift. In spite of these changes, we conclude that equities are likely to rebound from recent strife and work their way higher this year. The bull market in stocks won’t last forever. But, for now, it isn’t at an end.