Markets

2016 Stock Market Outlook

A list of stock prices rising and declining in value
Credit: Shutterstock photo

The best part of the 2016 investment landscape is that it looks just like last year. This means we can use the lessons learned from 2015 to carve out extra stock market profits.

And the worst part is... it will look just like last year. That means limited gains for the main indices and spells of nasty volatility.

Gladly I think the pros beat the cons in this scenario... because where else are you going to put your money???

Cash is still trash.

The 33 year bond rally is over as rates will likely rise from here.

Real estate will lose luster as rising rates put pressure on home prices as well.

So the stock market still offers the best place to find outperformance. That is not necessarily true if you are just an index or mutual fund investor as your returns will likely be in the low single digits.

Instead this is the year of the stock picker. Meaning the average stock is going virtually nowhere. However, if you stack the odds in your favor by selecting the kind of stocks that are proven to outperform, then you will enjoy attractive returns.

In the rest of the article I will cover these topics to get you in the best position to prosper in the year ahead:

1) Why Still Bullish?

2) Predictions

3) Potential Pitfalls

4) How to Stack the Odds in Your Favor

MORE . . .

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Your Holiday Gift from Zacks

We want to express appreciation to our Weekend Wisdom readers, so you are invited to choose from two just-released Special Reports with our compliments. Please click one of the following:

1) Gift for Long-Term Investors: 5 Stocks Set to Double >>

Each ticker was selected by a Zacks expert for potential to increase +100% and more through the coming year.

2) Gift for Short-Term Traders: 7 Best Stocks to Kick-Start 2016 >>

Culled from today's 220 Zacks Strong Buys, these 7 have been tabbed as timely buys to break out early in 2016.

Enjoy these special reports. And may your New Year be filled with joy and prosperity.

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Why Still Bullish?

A long term bull market stays in place until one of two things happens:

A) Recession looms on the horizon awakening the next bear.

B) Valuations get stretched (Ex. The bear market that started in 2000)

As for a recession looming on the horizon, that just doesn't add up as the US economy continues to grow at a +2% clip. I know that doesn't get your engines revving, but it is a consistent pace that makes this one of the longest expansions and bull markets in history.

I appreciate that on average there has been a recession every 5-6 years. But that is often because the boom times are too good leading to excesses that bring to life the next contraction. The beauty of this Muddle Through 2% growth is that there are no excesses or bubbles at this time. So no serious fear of an imminent recession.

Now let's address the other side of the coin...valuation. I know folks who point to a historical average PE of 15 in order to say that this market is getting stretched given the trailing PE of 17.7. However, there is much more to the story.

First, the market looks forward. In this case we should be looking at the PE based upon estimates for the coming year, which are in the neighborhood of $126 per share for the S&P 500. That creates a PE of 16.3 at this time.

Second, PEs in the latter stages of bull markets typically move higher given the confidence folks have in a positive outcome. So a PE of 17-18 is more standard at this stage of the game.

Lastly, and most importantly, is the relationship stocks have with Treasury rates. In general, the earnings yield for stocks is 3% higher than the 10 year Treasury. So let's do that math.

Earnings yield is the inverse of PE. So you need to divide the $126 in expected earnings for the S&P 500 by its recent closing price to come out with an earnings yield of 6.1%. Whereas the 10 year Treasury is only providing a meager 2.2% yield for investors. Given this historical relationship, there is still ample upside for stocks. ( What if rates keep rising? More on that topic in the "Potential Pitfalls" section below).

2016 Predictions

This bull market has already rallied more than 200% since it began in March 2009. Thus, the easy money has been made, which explains the basically breakeven performance in 2015. Unfortunately the results for 2016 are not looking much better.

In some of my recent commentaries I have shared the following equation to predict future stock market returns. Here it is again:

GDP growth + dividends + inflation

The first two items get you to around +4%. Inflation is the bigger mystery. Let's call it 1%. So all together we are looking at around 5% gains from the stock market in 2016.

10% is not out of the question if GDP and earnings growth escalate from current levels. Unfortunately another 0% showing is just as possible.

Weighing out all the possibilities, I expect the S&P 500 to end the 2016 campaign a notch higher between 2150 to 2200.

Potential Pitfalls

The outlook shared above is based upon the information in hand. As things evolve it may get better...or may get worse. So let me now prepare you for 2 potential hazards out there.

1) Recession: The average expansion period for the US economy lasts for 63 months before the next recession arrives. Gladly history does not repeat itself like clockwork as right now we are in month 82 of this growth phase.

Again, the #1 cause of bear markets is a recession. So as this expansion gets longer in the tooth, we all need to be on active watch for any signs of contraction. When that happens, it is time to lighten the load and get prepared for the next bear market.

2) Treasury Bond Rates: As shared earlier, there is an important historical relationship between Treasury bond rates and the valuation of the stock market. Right now that is still very favorable for stocks as bond rates are near historic lows.

However, in December the Fed raised rates for the first time since 2006. This has pushed up the rates on some short term bonds, but amazingly the 10 year Treasury rate is actually a notch lower than before the announcement.

Why?

Because the Fed has promised to exercise great caution in making future rate hike decisions. In fact, the Fed members have already predicted that the Funds Rate will likely be between 1.25% and 1.5% at the end of 2016. Add virtually no inflation on top of that and there is no current reason for the 10 year rate to move markedly higher. And thus stocks are still attractive.

If the Fed moves faster than expected, or inflation kicks up, then yes 10 year Treasury rates will rise. I believe stocks will do fine if rates just float up to around 3%. Above that level and it will start to call into question the relative value of stocks versus bonds, which would spark a correction even if other economic indicators are positive. So be sure to keep tabs on how this progresses over time.

How to Stack the Odds in Your Favor

Overall the stock market is still the best place to find solid investment returns. And the Zacks Rank is the time-proven method for significantly outperforming the S&P 500.

With this in mind, I invite you to choose from two holiday gifts with our gratitude for being a valued member of our Zacks community. Both are timely Special Reports "hot off the presses." Both offer a good start for conquering the challenge and fulfilling the promise of 2016.

Are you mostly inclined to long-term investing?

Then pick our "5 Stocks Set to Double" report. Each of these companies shows exceptional potential for gains of +100% or more through the coming year.

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Do you lean more toward short-term trading?

Then pick the "7 Best Stocks to Kick-Start 2016" report. Our experts culled these 7 stocks from today's Zacks Rank #1 Strong Buys as most likely for early breakout in 2016.

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Whichever gift you choose, I wish you happiness, health, and outstanding investment success in the year ahead.

Best Regards,

Steve

Steve Reitmeister has been with Zacks since 1999 and currently serves as the Executive Vice President in charge of Zacks.com and all of its leading products for individual investors. He is also the Editor of his personal portfolio service, the Reitmeister Trading Alert.

Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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