Wells Fargo’s Gina Martin Adams was the most bearish strategist on Wall Street in 2013, sticking to her 1440 year-end S&P 500 target the whole way through, even as others revised their forecasts up on account of rising stock prices (the index closed the year at 1848).
Adams just published her 2014 outlook, and her new year-end S&P 500 target of 1850 — just above Monday’s close of 1837 — is once again the lowest on the Street (although this year, she’s joined at the bottom of the range of forecasts by Deutsche Bank’s David Bianco and Barry Banister at Stifel Nicolaus, who both share her new target).
Here’s the wild part: Adams says she “wouldn’t be surprised to see the index trade as high as 2,100 and as low as 1,500 at some stage throughout the year.” Needless to say, that’s a big range.
“Indeed, we expect 2014 to be filled with both thrills and chills for equity investors, offering both bulls and bears something to feast on,” says Adams.
On one hand, Adams expects growth in earnings per share to accelerate this year.
“We forecast S&P 500 EPS growth should accelerate from 4% in 2013 to 7% in 2014 and 6% in 2015,” she writes. “In our view, slightly stronger growth in earnings should be driven by better revenue growth via stronger business investment, export growth, and a reduced drag from fiscal tightening.”
This forecast is still below Wall Street’s consensus estimate, which sees EPS growth accelerating to 11% in 2014 and 10% in 2015, but the modest acceleration Adams predicts is nonetheless what she refers to as “the thrills” for investors.
The “chills,” on the other hand, relate to valuations, which Adams contends are 20% too high at current levels, based on a model that takes interest rates, inflation, demographics, and private sector GDP growth as inputs.
“Indeed, the current [price to earnings] ratio is 17x, 18% above long-term average of 14.4x and 6.9% above the post-WWII average of 15.9x,” says Adams. “Likewise, most measures that offer a broader perspective of valuation also suggest the S&P 500 is currently overvalued relative to history. For instance, the cyclically-adjusted PE ratio (CAPE, also referred to as the Shiller PE) is 25.1x, a level exceeded only 4 times in the last century. Likewise, Tobin’s Q suggests companies are priced at 0.99x.”
Of the four factors in Wells Fargo’s valuation model — interest rates, inflation, demographics, and private sector GDP growth — Adams says “interest rates are likely to impact the multiple most profoundly in 2014.”
In other words, as the Federal Reserve winds down its quantitative easing program this year and interest rates go higher, Adams believes the stock market will eventually feel the pain.
In her outlook, she writes:
While the Fed’s modest taper has thus far proven a non-event for stocks, an eventual end to QE may still prove rather troubling for investor risk tolerance. As evidenced by the 24% drop in the S&P 500 PE affiliated with the end of QE1 and the 22% drop in PE that occurred with the end of QE2, risk tolerance has historically struggled to absorb bearish changes in quantitative easing (QE) programs.
Even if QE manages to end without fireworks in 2014 (it’s a big IF, in our view), investors may have to price stocks for tightening in the target rate in 2015. Historically, stocks tend to struggle most with rate increases in the six months prior to and six months just after the first tightening. If the first tightening is June 2015, as the current futures markets suggest, the multiple may start to reflect concerns over future tightening as early as late 2014. The PE trend in the last two tightening cycles shows just how much stocks tend to react to future rate hikes.
While investors should continue to enjoy extremely low short rates for now, it seems likely that by the end of 2014 they may be looking forward to tightening in 2015. This combination of near-term scaling and end to QE, ultimately feeding through to higher short rates 18-24 months from now could prove difficult for the PE to absorb. As it happens, the average multiple contraction affiliated with the last four negative policy shifts (1994, 2004, 2010, 2011) is 23% — right in line with our model’s implied contraction of 20%.
Adams suggests clients overweight their portfolio allocations to stocks in the technology, health care, and financials sectors in 2014 while underweighting allocations to stocks in the consumer staples, utilities, telecom, energy, and materials sectors, based on relative valuations.