Over the last several months, the stock market has been gyrating between the likelihood of two distinct events. One possibility is the Euro collapsing, leading to a worldwide recession. The other is the possibility that Europe addresses its problems and a recession is avoided. The likelihood is greater that Europe addresses its problems, though a breakdown of the Euro still remains a possibility.
I will attempt to analyze how the stock market will perform under the two different scenarios. For 2011, earnings for the S&P 500, an index of 500 large companies, are projected to be $98/share. Over long periods of time, stocks have averaged trading at about 15 times yearly earnings. For real estate investors, this concept is similar to how much a property is worth based on annual rents.
With the S&P 500 trading around 1,260, as of Dec. 5, the stock market appears to be a good bargain, as the current multiple is less than 13, with 15 being normal. However, the stock market is discounting a certain probability that the Euro-zone problems escalate, causing a major recession.
The most likely scenario is that Europe averts disaster, but a number of European countries still experience a mild recession in 2012. Under this scenario, the United States can still experience moderate growth in 2012, but earnings growth for many companies will slow because of their significant European presence. Overall earnings may only increase from $98 to $100, but as uncertainty is lifted, the multiple for the S&P 500 should get closer to its normal level of 15, which with earnings of $100, translates to a target of 1,500.
In the other scenario, the Euro collapses, causing a severe recession in Europe and a moderate downturn in the U.S. In this scenario, earnings for the S&P 500 could possibly drop 30%, to $68 and, applying the same 15 multiple, gets a price target of 1,020.
Looking at these numbers closely, notice that the upside and the downside for the market is the same. A reader may think if the upside and the downside are equal, the stock market does not look very attractive, which is true if the probabilities of both outcomes are the same. However, the likelihood of Europe addressing its problems and avoiding collapse is about 80%. This is based on the fact that the Federal Reserve and other central banks are getting involved, and it is in Germany’s interest to reach a compromise with other European counties.
The price targets I gave are very rough approximations and certainly other potential outcomes may occur. If someone believes the likelihood of a Euro collapse is closer to 50%, a more cautious stance on the market would be warranted. However, if you believe the probability of a financial crisis is rather unlikely, there is still significant upside to the market and you would, therefore, want to keep at least a normal position in stocks without becoming overly aggressive, as there is still a possibility that things could come apart in Europe.
