Post from First Trust Economics Blog

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist 

Dec. 13th, 2021

We were bullish in 2021 and bullishness obviously paid off.

As of the Friday close, the S&P 500 is up more than 25% so far

this year. Meanwhile, a 10-year Treasury Note purchased at the

end of 2020 has generated a negative total return, as interest

earnings have been more than offset by capital losses.

The reason we were bullish a year ago even amid

widespread fears about COVID-19, is because we stick to

fundamentals, assessing fair value by using economy-wide

profits and interest rates, what we call our Capitalized Profits

Model. And, one year, later, we are still sticking with

fundamentals. Our year-end 2022 call for the S&P 500 is 5,250

(up 11.4% from last Friday), and we expect the Dow Jones

Industrial Average to rise to 40,000.

The Capitalized Profits Model takes the government’s

measure of profits from the GDP reports, discounted by the 10-

year US Treasury note yield, to calculate fair value. Corporate

profits for the third quarter were up 20.7% versus a year ago, up

22.3% versus the pre-COVID peak at the end of 2019, and at a

record high.

The key question then becomes what discount rate should

we use? If we use 1.50%, roughly the current 10-year Treasury

yield, our model suggests the S&P 500 is grossly undervalued.

But, with the Federal Reserve still holding short-term interest

rates at artificially low levels, the 10-year yield might be

artificially low, as well.

So, to be cautious, we plug in some alternative higher longterm

interest rates. Using third quarter profits, it would take a

10-year yield of about 2.75% for our model to show that the stock

market is currently trading at fair value. And that assumes no

further growth in profits.

We expect the 10-year Note yield to finish 2022 in the

vicinity of 2.00%. Nonetheless, we have chosen to use a more

conservative discount rate of roughly 2.50%. Using third quarter

2021 profits, that creates a fair value estimate for the S&P 500 of

5,250. And this does not take into account higher profits in the

year ahead.

The bottom line is that although we remain bullish, we are

not quite as bullish as in recent years, projecting an increase in

stocks of 11.4% from Friday’s level. We haven’t had a 10%

correction in 2021, and, although we never try to time the market,

we wouldn’t at all be surprised by one happening at some point

in 2022. Moreover, the stock market is likely to grapple with

either higher short-term rates in 2022 or, in the alternative, a

Federal Reserve that is even further behind the inflation curve,

risking a higher peak for short-term rates sometime in the future.

Another issue is the battle between fading fiscal stimulus

and a gradual return to normalcy. The budget deficit will still be

very large this year even if the Democrats-only “Build Back

Better” proposal doesn’t pass. But the deficit will be much

smaller than the past two years. That will generate a short-term

headwind for growth. Meanwhile, more businesses should be

getting back to normal and small business start-ups gradually

replacing businesses that were killed off by overly strict COVID

rules.

On net, this adds up to a scenario that is likely to be

constructive for equities. We’ve been bullish since 2009 but we

are not perma-bulls. There are clouds on the horizon, and at

some point in the next few years, we may be (temporarily) bullish

no more. In the meantime, though, the clouds are on the horizon,

not overhead. Equities have further to run.