Investing

Why Merrill Lynch Sees the Stock Market Rising Even More in 2018

Jon C. Ogg

Published: January 23, 2018 11:30 am

Last Updated: January 12, 2020 4:13 am

The start of 2018 has been more than impressive. After the Dow Jones Industrial Average rose about 25% and the S&P 500 rose more than 19 in 2017, both major stock market indexes were already up 5% after just three weeks into the new year. It may be obvious that gains of this magnitude cannot continue indefinitely without a correction, but the bullish sentiment from analysts, economists, market strategists and investors has become even more robust on the heels of tax reform and on corporate growth.

Merrill Lynch has just joined the more bullish camp for stocks in 2018. The firm’s chief equity strategist is Savita Subramanian, and she has just raised her 2018 year-end target for the S&P 500 to 3,000 from 2,800.

Driving the higher targets is a rise in sentiment across many measures. There are still some warnings in the note, such us looking at quality companies and minding corporate debt levels.

Merrill Lynch’s sell-side (sentiment) indicator has risen by almost five points since just the end of 2017. This has driven investment strategists to increase their equity allocation recommendations, and the Global Fund Manager Survey most recently showed cash allocations hitting a five-year low of just 4.4%.

While this bullishness may spook some investors who haven’t forgotten that the stock market can correct 5% or more, Subramanian maintained that these indicators are not at any bullish extremes that are typically seen at the end of bull markets.

Another driving force for equities is that the great rotation out of bonds into stocks still has not taken place. Stock market valuations are called “elevated on most measures,” but it was shown that stocks still appear historically cheap, and by a wide margin, relative to bonds.

The new 3,000 target for the S&P 500 is based on four of the five target models and Merrill Lynch’s 6% higher normalized earnings per share forecast taking tax reform into consideration. The 3,000 target was generated from a 2,636 fair value model, followed by targets of 3,079 in sentiment (sell-side), 3,108 in estimate revisions, 2,971 in the long-term valuation model and 3,022 in the year-ahead price momentum model.

Again, there is at least some caution as the 3,000 target would imply gains of about 5.7% from current levels. Subramanian’s forecast said:

We are watching for signs to temper our enthusiasm on the S&P 500. And with 11 of our 19 bear market signposts having been triggered, the risk-adjusted reward of stocks appears less compelling. But note that since 1968, at least 80% of our signposts have been signaled ahead of prior market peaks… Meanwhile, our volatility indicator suggests a pickup should occur right about now… Our regime model indicates we are in a phase during which a high quality bias doesn’t hurt, and may be moving into a phase in which it greatly helps.

Merrill Lynch also is calling for higher corporate spending in all categories to occur. This is after repatriation and a lower corporate tax being accompanied by a sales recovery. Stock buybacks are expected to benefit from the repatriation proceeds, but the cyclical case for capital spending (with immediate expensing in tax reform) is strong. Two potential corporate spending surprises were shown to be a record year for M&A and also paying down debt when there is higher leverage and rising interest rates.

The Merrill Lynch target for the S&P 500 for 2017 earnings is for a gain of 12% (over 2016) to $132 per share. That is then followed by a 16% projected growth to $153 per share in 2018 and 5% growth to $161 per share in 2019.

As far as whether this will mean the end of the bull market is near, that’s not the current Merrill Lynch view either. With a longer-term horizon out to 2025, the current target would put the S&P 500 at 3,500 or so, implying annualized price returns of 3% to 4% per year, along with a 2% dividend yield.