Each year at this time we start seeing predictions for the coming year floating around. Following a strong finish to the year combined with overwhelming enthusiasm for a Republican led White House & Congress the expectations for 2017 are high. When emotions are strong it is best to do what we always do at SEM — look at the data.
Inside every “price target” are two variables — Earnings & the expected P/E Ratio. Following an “earnings recession” in 2015/16 due to a strong dollar and a collapse in energy company earnings, analysts are expecting 20% growth of earnings in 2017. The P/E ratio is already well above average & at levels we could objectively consider overvalued (see bonus Chart of the Week at the bottom of the page). This means earnings need to meet or beat these strong expectations in order for stock prices to remain high. If earnings growth does not match and/or valuation levels return to more “normal” levels stocks could run into trouble in the year ahead.
Looking at the chart it is easy to see the risks in 2017 — Stocks must remain in OVERVALUED territory for a positive 2017. Of course the chances of earnings disappointing and investors being willing to continue paying 22x earnings are slim. If stocks were to return to “fair value” of 17x earnings, at best stocks will be flat & at worst could be down as much as 19%. I don’t see much chance, short of a recession of stocks returning to “undervalued” territory, but we can see the downside risk if a recession does emerge.
So the objective best case for stocks is +27% if we see 20% earnings growth & stock valuations remaining high. The worst case is a drop of 20% (or more) if we see earnings growth of 6% & a return to “average” valuations. Understanding this, we need to have a nearly perfect environment for buy & hold investors to make money in stocks. Expectations are high, which means the chances of disappointment are also high. When investors are disappointed they often react emotionally which means we could see valuations moving lower relatively quickly. Plan accordingly.