Three Components Will Determine 2013

By David Waddell

Forecasting 2013 The fiscal cliff episode proved bullish for stocks. Fearful asset owners facing tax code uncertainty pulled outsized income and capital gains into 2012. Sellers quickly became buyers to complete the tax arbitrage. For the week ended Jan. 9, investors poured $18.3 billion into stock mutual funds and ETFs, the largest combined inflow in five years. This capital re-commitment has propelled the S&P 500 3.25 percent higher in 2013. Does this mean that 2013 will continue to see fantastic equity returns? Domestic stock returns are driven by three primary components – earnings, dividends and valuations. Let’s consider each to arrive at our forecast.

2013 Earnings Full year 2012 earnings for the S&P 500 companies should approximate $99, for an annual growth rate of 3 percent. Current forecasts for 2013 imply an earnings growth rate of 13 percent. This rosy outlook resembles the one held by the street this time last year, and growth expectations faded as the year progressed. With margins already high and the economy hampered by U.S. austerity measures, expectations for back-end loaded growth of 13 percent seems a bit too optimistic. To be conservative, let’s assume the economy does accelerate a bit, and companies can double 2012’s growth rate to 6 percent for a total of $105.

2013 Dividends 400 of the 500 companies in the S&P 500 pay dividends. Across the index, the dividend yield is just above 2 percent, in line with the 10-year average. While dividends and payout initiations may tick higher in 2013, the dividend yield doesn’t fluctuate much. It’s safe to assume that dividends will contribute another 2 percent to total return in 2013.

2013 Valuations In the long term, stock market returns true up to earnings and dividend growth. In the short term, valuations wag the dog. Consider 2012. The S&P 500 grew 16 percent to 1425. Earnings grew 3 percent, dividends contributed 2 percent, and the remaining 11 percent came from an increase in valuation. The S&P 500 finished 2012 with a trailing P/E of 14.5. A trailing one-year P/E of 14.5 for the S&P 500 is neither cheap nor expensive compared with its long term average of 15. However, analysis done on P/E ratios and market forecasting indicates that longer term measures have far greater predictive ability. Looking at five-year trailing earnings data, market valuations appear pretty lofty. According to the five-year data (the set we pay attention to) the current P/E multiple is 19.5, above the 16.5 median since 1926.

So while the S&P 500 has fundamental tailwinds with potential earnings growth of 6 percent and a 2 percent contribution from dividends, the case for P/E expansion seems limited. However, valuations amount to a barometer of confidence. Higher investor confidence equals higher multiples, higher indices and vice versa. For the purposes of forecasting, start with a fundamental 8 percent gain to 1540 and then add or subtract based upon where you think investor psychology will be on Dec. 31. You are now a Wall Street forecaster.

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.