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.
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.
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.
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.
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.
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.
Finally, foreign equities offer similar growth estimates but lower valuations: Foreign developed, emerging and small-cap markets trade at discounts relative to U.S. markets.
In all, we label ourselves “bulls,” but emphasize a lower case “B”.