The S&P 500 in 2016: What to Expect

Image: Flickr user Andreas Poike.

2015 has been the most challenging year for the S&P 500 (^GSPC 0.02%) that investors have seen since the financial crisis, and with less than two weeks to go in the year, it's far from certain whether the key market benchmark will eke out a positive total return for the seventh straight year or not. Although the market swoon during the summer didn't qualify for a full-blown bear market for the S&P 500, it nevertheless reminded investors that stocks don't move straight up, and some now believe that the market is long overdue for a more sustained correction. Let's take a look at some of the factors that will drive the S&P 500's performance in 2016.

Will the economy support higher stock prices?
Part of the reason why stocks have seen their returns held back in 2015 is that corporate earnings haven't been as strong as they have in recent years. Plunging oil prices created a major disruption in the energy sector and in related industries like equipment, and that has created a drag on earnings and revenue. Currently, analysts expect earnings to fall by about 4% when S&P 500 companies report their fourth-quarter earnings early next year, and sales will decline about 3%. If things work out that way, then S&P 500 earnings will fall in 2015 for the first time in six years.

For 2016, however, most investors see earnings growth returning to the market. Currently, the consensus forecast for earnings growth in 2016 is nearly 8%, and sales gains of between 4% and 5% could help support a higher market as well. Investors expect the energy sector to continue to lag next year, especially given that crude oil prices have fallen further late in the current year. However, strength in areas like healthcare and consumer discretionary stocks could offset weaker energy-related earnings and promote overall growth for the U.S. economy.

Valuations and interest rates
Many investors remain concerned that valuations in the stock market seem high. As of the end of November, the S&P 500's trailing earnings multiple was nearly 22, with a projected forward P/E ratio of about 17. Using economist Robert Shiller's CAPE ratio, which reflects an adjustment for cyclical oscillations in the economy, the S&P 500's valuation climbs to 26. Those figures are generally on the high side of historical norms, but not at unprecedented high levels.

The biggest concern for investors should be whether interest rates remain in check. The Federal Reserve took action earlier this month to raise short-term interest rates for the first time in nearly a decade, and so far, the longer end of the fixed-income market has avoided a big rise in rates in response. Low long-term rates arguably make higher valuations in the stock market make more sense, as the fixed-income market isn't providing any viable alternatives to stock market investing. Indeed, the combination of low rates and the risk of bond price declines could help send more money into the stock market, at least until bond yields rise to the point at which they're attractive enough to draw money out of stocks. If rates remain unattractively low, then stocks will look appealing by comparison, and that would help the S&P's performance in 2016.

Why the answer doesn't matter
It's interesting to think about what will happen to the S&P 500 in 2016, but for long-term investors, it's not a critical concern. Obviously, no one wants to buy into the stock market just before it suffers a big decline. But given enough time, even a big decline eventually gives way to long-term gains.

For instance, consider those who bought the S&P 500 near its peak eight years ago. Investors endured a gut-wrenching drop of more than a third in 2008, but those who stayed the course and held on have seen the index rise at a 4.3% annualized rate since then. Moreover, dividend income has added another couple percentage points to that annual average.

The S&P 500 is always vulnerable to unexpected bad news, but fundamentally, its prospects look solid. It's impossible to predict exactly how the S&P 500 will do in 2016, but the odds of good gains for the index look as favorable as they've always been for stock investors.