The big question in the market never changes.
Investors only want to know one thing: What's next?
To the degree that such a question is answerable, one must consider four aspects.
1. The Historical Underpinnings
The long-term ability of the market to generate returns suggests investors can expect an annualized gain of 9.43%, which assumes that all dividends are reinvested. This is the total return of the S&P 500 since 1965, which I cribbed from inside the front cover of the Berkshire Hathaway (NYSE: BRK-B) annual report. The best year during this time period was 1995, with a 37.6% gain, and the worst was 2008, with a 37.0% loss. The average was 11.0%.
Even so, the average holds, and it holds any way you slice it. Whether we look at the past half-century as one running block of time or as four decades (with two outstanding periods, one lackluster decade and one abysmal 10-year stretch), we still see that the compound annual growth rate of 9.43% is a good "average" benchmark.
As 2011 was a subpar year, the historical data suggest 2012 has a relatively stronger chance of being positive than negative. Excepting 2001-2003, in the past 10 instances when the market had a below-average return, the following year it returned an average 21.5%.
2. The Fundamental Perspective
Though the economy continues to circle the drain, from a fundamental perspective, stocks look great. Companies have a lot of cash on hand. Management has adjusted to the economic realities and earnings are strong.
The S&P 500 is trading at an aggregate 13.2 times earnings. This seems very low.
In the 1990s, investors saw the market valued at 21.3 times earnings. The next decade, that fell a little, to 19.6, but it was still a nice "new normal" compared with what investors had grown accustomed to in the 1970s and 1980s, when the average earnings multiple of the market's benchmark average hovered at 12.7 and 12.2, respectively.
The 1960s were a little headier: the market's price to earnings (P/E) ratio was an average 17.6, which seemed like progress from the 1950s, when it was at about 14. All in all, the average earnings multiple of the S&P 500 from 1954 to the present is 16.4.
This works in pretty nicely with the other numbers. It will take a 24.2% gain for the valuation of the index to move from its current 13.2 times earnings to its historical average of 16.4, which is in line with my conclusion from the historical data.
3. The Black Swan
Anyone who's invested even $100 in the market in the past decade knows one thing (and perhaps only this one thing) to be true: Anything can happen. Anything.
The world can change, and it can change overnight. The hell of the deal is that despite instant communication and better -- or at least more -- information, we can still be almost absolutely surprised.
Be it an economic calamity like the financial crisis, an act of God like the earthquake/tsunami that struck Japan, or an act of madmen such as a terrorist attack or coup d'etat, the markets are at constant risk of panic. Plus, all markets are interconnected to a greater degree than ever before, so what once might have been a bad day in Madrid now becomes an opportunity for worldwide sell-off.
The advent of computerized trading to exploit these ripples doesn't help anything, at least not for individual investors.
So we may not know what is going to happen, but we have to acknowledge that some catastrophic event could knock the markets off kilter. The worst-case scenario at this point, absent a mass-scale terrorist attack, rogue nuclear launch or natural disaster, is major trouble in Europe. The looming debt crisis there and the lack of clarity about the future of the euro means events could well render any forecast or strategy moot.
This cannot easily be hedged against, but it is a good reminder as you consider your portfolio allocation for the year. Ask yourself what the risks you shoulder really are, and if you are comfortable with them.
What will 2012 look like for a major blue-chip U.S. company?
To determine that, we'll take a brief look at venerable consumer products company Procter and Gamble (NYSE: PG). The company is on track to record $82 billion in revenue in 2011 with net earnings of about $11.2 billion. With 2.8 billion shares outstanding, that's some $4.07 in earnings per share (EPS). P&G shares are at about $66, so its P/E ratio is 16.2 ($66/$4.07).
What would it take for a company like P&G to see a 24.2% gain?
There are only two answers to the question.
First, it could see an increase in its valuation. As it is trading at its two-year average, this seems mildly unlikely. However, its five-year average earnings multiple is 18.1, so assuming a rise in the overall market, it's not outside the realm of possibility to see P&G maintain its relative premium.
So if our target price is $82 (current price of $66 times a 24.2% gain) and we assume an earnings multiple of 18.1, then we'd need to see 2012 EPS of $4.53, which represents an 11.3% increase in earnings.
The trouble is, 11.3% of $82 billion is $9.18 billion. P&G hasn't posted growth of that magnitude in recent memory. Its more typical revenue growth rate is in the neighborhood of 2% to 4%, and it typically operates at a roughly 15% net margin.
If it comes, then the growth will likely have to come from Asia, where P&G is seeing strong growth, in the area of 10% a year. Last year's sales were $13.2 billion, which grows to $14.5 billion in 2012 if the trend holds. That helps, but it doesn't quite push the needle far enough. P&G needs an acquisition to do that -- a new product line that will immediately add to the company's top and bottom line. It has a very high "AA" credit rating and several billion in cash on hand, so one major or two mid-sized acquisitions could do a lot to juice Procter & Gamble's bottom line.
So, in sum, almost everything has to line up for the company. It has to maintain current U.S. sales, continue its upswing in China and manage costs worldwide. The market has to see a premium value in a stable company, and P&G investors need to count on a rising tide lifting all boats and that the shares hang on to their relative premium.
That said, a well-conceived acquisition or stronger-than-expected performance, on top of any sort of economic recovery, could do great things for these shares. I expect P&G to keep pace with the overall market.
What then, after all that, is next?
Because the likelihood of a black swan increases the commensurate chance for volatility, the watchword for the upcoming year should be caution. Don't be afraid to take your chips off the table for a while -- even after you reassess your risk tolerance for 2012.
The Investing Answer: My prediction is that the overall market in 2012 will follow history and experience a strong year. The average 24.2% return after a below-par year, however, appears far too rich, especially for large cap companies like P&G with limited growth ability. The market's average compound annual growth rate of 9.43% is likely a far more reasonable expectation.