Economic Insights - January 2016

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We will focus on the outlook for U.S. stocks and what this could mean for your personal finances.

We expect the S&P 500 to end 2016 at 2,375, 15.7 percent above current levels. This is based on our Capitalized Profits Model, which discounts corporate profits by the 10-year Treasury yield.

Given a 10-year Treasury yield that currently stands at 2.25 percent, the “raw” version of the model says the S&P 500 is “worth” 4,228. Obviously, that’s insanely high. But this number is artificially high because Fed policy is still holding the yield curve “artificially low.” Using a more reasonable 10-year discount rate of 4 percent instead gives us a “fair value” calculation of 2,378.

And if we’re wrong about interest rates, if long-term yields remain low much longer than we think, then we’re being too pessimistic about equities. A discount rate of 3.25 percent, for example, would put fair value at 2,925.

Another way to think of this is that if the “new normal” crowd is right and interest rates stay low, then stocks have to go to much higher levels before future returns would be held down significantly.

For now, we still think the 10-year yield is eventually headed for 4 percent. Over long periods of time, the 10-year yield tends to equal nominal GDP growth, which is simply real GDP growth plus inflation. The Federal Reserve projects that nominal GDP growth will hover around 4 percent per year over the longer run, which is consistent with a 10-year yield of 4 percent.

It’s true that the 10-year yield has fallen short of nominal GDP growth over the past five years, but over the past ten years (through the third quarter), the Note yield has averaged 3.17 percent, while nominal GDP growth has averaged 3.18 percent. In other words, the alleged “broken link” between yields and the economy is an artifact of the time period chosen.

However, because the Fed will lift rates in a gradual and patient manner, we forecast the 10-year yield will end next year at 3 percent. As a result, any shortfall in stock performance will not be due to a rapid increase in interest rates. If you want to worry about our forecast for stocks, you should focus on profits.

We are not worried all that much about profits, either....

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