Some naysayers believe the outlook for stocks in 2016 is lackluster. While cynics cling to fears that weak consumer spending, rising interest rates, a strong dollar, and political pressures pose significant threats to the market, my 2016 stock market outlook is more optimistic. Despite the series of market declines we have been experiencing recently, I think the broad U.S. stock market (represented by the S&P 500 Index) could achieve double-digit gains in 2016, driven by improved consumer spending and better clarity concerning Federal Reserve (Fed) policy. On the one hand, market pullbacks can be unsettling—on the other hand, they could be viewed as opportunities to purchase select companies at more attractive prices. Even more pronounced appreciation may be achieved through an increased focus on stock selection.
- Stronger consumer spending
Consumer spending plays a key role in driving the U.S. economy, accounting for about two-thirds of overall economic output—so, when consumers start spending more, it’s a big boost for the economy and the market. I think recent financial data has been trending favorably for consumers and that they may be inclined to increase their spending in 2016 as a result. Chart 1 shows that employment and wage growth have continued to improve. Cheap gasoline prices at the pump have benefited consumers’ financial situations as well. These factors likely have contributed to improving consumer confidence: With its December reading, the University of Michigan’s Consumer Sentiment Index achieved an average reading of 92.9 for 2015, its highest annual average in 11 years. Consumers are feeling better about their situations, which could bode well for increased consumer spending this year.
- Greater clarity around Fed actions
Uncertainty about Fed policy created issues for stocks in 2015. The Federal Open Market Committee’s (FOMC’s) decision in December to initiate its first short-term interest-rate increase should drive away some of the uncertainty. The Fed’s plan is now underway, bringing investors increased clarity, which they like. FOMC members were clear in their view that “with gradual adjustments in the stance of monetary policy, economic activity will continue to expand at a moderate pace and labor market indicators will continue to strengthen.” They also sent a consistent message that “economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain for some time below levels that are expected to prevail in the longer run.”
Greater interest-rate clarity may lead to more confident investors who are willing to pay a greater premium for stocks—which could drive higher price/earnings (P/E) multiples and, in turn, higher stock prices. Today, the S&P 500 Index is trading at around 15 times the next 12 months’ earnings. In a market where there is greater clarity and a better comfort level, that P/E multiple could rise to 17.5—which equates to a rising stock market. While the market is not cheap at this point, it does not seem overly expensive to me, either, and recent heightened volatility has led to some attractive pricing opportunities. Increases in earnings and rising P/E multiples could drive continued stock appreciation.
There is a difference between an overvalued market and a market that’s valued more highly than long-term averages. Higher-than-average valuations might be justified, depending on overarching economic conditions. Whenever stocks climb higher than long-term averages, the first question investors should ask is whether there are fundamental reasons behind it.
- Prudent selectivity among stocks
I am always focused on firms that can deliver positive earnings surprises. The ability to produce earnings and meet expectations tends to be especially rewarded in more of a middle-to-late cycle market, while earnings disappointments do not. Cautious investors are looking for the end of the bull run, and in this scenario they often are willing to dispense punishment one stock at a time when earnings fail to meet expectations.
Relative valuation and absolute valuation measures also are important to consider. Chart 3 shows that stocks with positive earnings surprises and low valuations outperformed the broad market by more than 50% over the long term. Disciplined stock pickers have been able to profit from systematically identifying stocks with these characteristics. I expect this trend may continue in the current market environment.
I continue to believe that investors should position themselves to benefit from steady, continued economic growth in the U.S. Also, I continue to favor a positive tilt toward momentum (relative strength) and stocks that can generate strong revenue and sales growth—especially select companies in the health care, information technology, and consumer discretionary sectors. I am less enthusiastic about stocks in the consumer staples sector, where earnings growth has been low.