We remain constructive on the outlook for the US equity market over the next year and continue to see upside potential for the S&P 500 Index to between 1250 and 1350 by the end of 2010.
Our estimate of downside risk for the S&P 500 remains, for the time being, 950 to 1000, but that range should rise over time as the economy recovers and earnings continue to improve.
With the S&P 500 currently at about 1110, the risk/reward ratio (now roughly 1.4-to-1) is not as favourable as it was earlier in the year, but there is still more upside than downside over the next year, in our view. Importantly, any meaningful correction would quickly tilt the odds in investors’ favour. At 1050, the risk/reward ratio on the S&P 500 jumps back over 3-to-1. At 1000, it is 12-to-1. We therefore believe a market correction should be seen as a buying opportunity.
Let us look at two views of the market. The first view says the market cannot go up because our current circumstances are too perilous and uncertain. The list of worries has been well chronicled by the media: a still-fragile financial system, a likely sub-par economic recovery, yawning budget and trade deficits, a vulnerable dollar, threats from both inflationary and deflationary forces, high and still-rising unemployment, continuing wars in Iraq and Afghanistan, nuclear sabre-rattling by Iran, massive funding requirements for social security, Medicare and Medicaid, the burden of health care reform and a probable rise in tax rates.
The second view says, yes, we have got plenty of things to worry about, but that has been true throughout history. Worries, concerns and problems are always an unavoidable part of the investment landscape, just as they are an unavoidable part of life. This view also looks past the current situation at the bigger picture. Over the long term, stocks have been great wealth builders. This has been especially true after they have suffered extended periods of poor performance, such as the 10-year period we have just witnessed. To be more specific, according to data compiled by Jeremy Siegel at the University of Pennsylvania, stocks have provided average annual real returns (after inflation) of 6.66% for all 10-year periods going back to 1871.
There have been 14 10-year periods, including the current one, where stock returns were negative. In the previous 13 instances, the subsequent 10-year returns have averaged 10% in real terms, about 50% better than the long-term average, and more than twice the return of bonds.
With funds currently flowing out of domestic equity mutual funds and pouring into bond funds, investors are being overwhelmingly influenced by the first of these views, but we think they are making a mistake.
David Nelson is chairman of investment policy committee, Legg Mason Capital Management
