S&P 3650, Dow 32500

A year ago, we projected the S&P 500 would hit 3100 at the end of 2019. In spite of the swoon in equities in the fourth quarter of last year, we didn't see a recession coming and our model for estimating fair value for the stock market was screaming BUY.

At mid-year, seeing the economic and trade-policy stars aligning for further growth, and with our model for equites (more on that below!) still showing room for gains, we lifted our year-end forecast to 3250. At a Friday close of 3169, we were only 2.6% below that level with 16 days to go.

For 2020, we remain bullish. Our call is for the S&P 500 to end the year at 3650, which is about 15% higher than it finished on Friday, with the Dow Jones Industrials' average moving up to 32500.

The first consideration we make when forecasting the stock market is whether we see a near-term recession. This step is important because even if the stock market is undervalued relative to long-term norms, a recession would almost certainly send equities lower in the short term; stocks would go from undervalued to more undervalued.

Needless to say, we don't see a recession anytime soon. The economy is still adapting to lower tax rates and monetary policy remains loose. In addition, home builders are still generating too few homes given our population growth and scrappage rates, while banks are sitting on ample capital.

The second step, and usually the most important one, is to use our Capitalized Profits Model. The model takes the government's measure of profits from the GDP reports, divided by interest rates, to measure fair value for stocks. Our traditional measure, using a current 10-year Treasury yield of 1.85% suggests the S&P 500 is grossly undervalued.

However, we think long-term interest rates are headed higher and this change can have a large effect on the model's assessment of fair value. We anticipate that the 10-year Treasury yield will finish the year at 2.5%. Using 2.5% (instead of 1.85%) suggests an S&P fair value of 3775. In other words, we should finish 2020 with more room for the bull market to keep running.