2011: Dow 14,500, S&P 1575, 10-Year 4%
First Trust Advisors
By Brian Wesbury and Robert Stein
January 3, 2011
Seven weeks ago our Monday Morning Outlook was titled “Stocks Are Cheap, Bonds Are Not.”
We said, “the bull market is still young….and bond yields are headed
higher.” Since then, the S&P 500 is up 6% and investors in the
10-year Treasury note have lost more than 4%.
Our
models tell us to expect more of the same in 2011. We use a capitalized
profits model to value stocks. We divide corporate profits by the
10-year Treasury yield, compare the result to each quarter for the past
60 years and use it to find an average fair value for stocks.
If
we use the 2010 year-end 10-year Treasury yield of 3.3%, this model
gives us a fair value estimate for the Dow of 23,500. But we believe the
Treasury bond market, which is being artificially manipulated by the
Federal Reserve, is in a bubble. To adjust for this, we use a more
conservative estimate for the 10-year T-note yield of 5% in our equity
model. This provides a “fair value” estimate of 15,500 on the Dow and
1675 for the S&P 500.
Getting
to fair value would require the US equity markets to rise roughly 34%
in 2011 – the largest one-year gain since 1975. Back in 1975, monetary
policy was extremely loose. In other words, with the Fed following a
highly accommodative monetary policy right now, this kind of outsized
gain in one year is entirely plausible.
But
there are some stumbling blocks to such a big gain. The market still
faces headwinds, such as financial difficulties in Europe and also in US
municipalities. Moreover, the markets rarely close large gaps to fair
value in one year. If often takes multiple years.
Offsetting
these headwinds are some tailwinds. Fiscal policy should move in a
better direction faster than is currently priced into the
market. President Obama wants to be re-elected to make sure his health
program is fully implemented. That will require moving in a free-market
direction on practically all other (non-health care) economic
issues. For example, don’t be surprised if the president proposes
significant changes to Social Security early this year, to make the
program more solvent over the long run.
The
net of these headwinds and tailwinds suggests that markets will have a
good year in 2011, but not close the gap to fair value in just 12
months. We think gains of roughly 25%, to 14,500 on the Dow and 1575 on
the S&P 500 at the end of 2011 is a very doable forecast.
Meanwhile,
our model of nominal GDP suggests continued upward pressure on Treasury
yields. In fact, we estimate the fair value yield for the 10-year
Treasury at 5%. However, with the Fed holding short-term rates at
essentially zero, we doubt the 10-year Treasury yield will be sustained
above 4%. We know of no time since the Fed was created in 1913 when the
10-year Treasury yield has been more than 400 basis points above the
funds rate, even in the inflationary 1970s. That anchor will not hold
the 10-year yield down forever, but we think it lasts through the end of
2011. Our call: a 10-year yield of 4% by year-end 2011.
This
information contains forward-looking statements about various economic
trends and strategies. You are cautioned that such forward-looking
statements are subject to significant business, economic and competitive
uncertainties and actual results could be materially different. There
are no guarantees associated with any forecast and the opinions stated
here are subject to change at any time and are the opinion of the
individual strategist. Data comes from the following sources: Census
Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the
Federal Reserve Board, and Haver Analytics. Data is taken from sources
generally believed to be reliable but no guarantee is given to its
accuracy.
(c) First Trust Advisors
www.ftportfolios.com
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