Bullish, but Not a Raging Bull
Wells Fargo's John Lynch likes big-caps, emerging markets and Microsoft, Cisco and Oracle. But he sees reasons to be cautious.
THE STOCK MARKET HAS STAGED a big rally recently. But now what? Stay with the rally? Take some money off the table? For insights, Barron's spoke by telephone last week with John Lynch, chief equity strategist at the Wells Fargo Funds Management Group. Lynch, 47, who is based in Charlotte, N.C., is for the most part upbeat about stocks, though he is concerned that the market is close to getting frothy. He tilts to large-cap stocks over small-caps, and emerging markets over domestic. As for sectors, his Overweight recommendations are technology, energy, materials and industrials. He is underweight consumer discretionary and staples. To learn his reasoning, read on.
Barron's: Let's start with the big picture. What's your assessment of stocks?
Lynch: The equity markets look pretty good. We've gained significant technical strength over these past three months. We had a good July and then, despite all the merger-and-acquisition activity in August, the market really didn't react. It was Federal Reserve Chairman Ben Bernanke's speech in late August that really got us over the hump. Last year, we talked about a 2010 trading range for the S&P 500 of 1050 to 1250. With the S&P 500 above 1200, we are near the upper end of that range, and the technicals look pretty strong.
Could you give a few examples?
The percentage of stocks on the New York Stock Exchange trading above their 200-day moving average looks very good. What is known as the MACD, or moving average convergence-divergence, line looks very good. The VIX index, which measures implied volatility, seems to be behaving, so investors don't seem to be too skittish. I am alarmed, though, at the relative strength index, which looks like we are overbought. So if there is a mixed signal in terms of the technical indicators, it would be that index [which gauges a market's momentum, based on current and past closing prices].
Which of Bernanke's speeches are you referring to?
In late August, he gave a speech at the Jackson Hole conference. That's where he really telegraphed the whole QE2 [quantitative easing, part two]. After he telegraphed that, we had the major September and October rally. That part of it was based on fundamentals. We had better-than-expected earnings. The market rallied around the fact that it was less likely we would have a double-dip recession. The market also priced in the midterm elections, and it turned out the market got it right this time. So you had a confluence of technical and fundamental events supporting the market north of the April highs.
What are your key themes in the equity markets?
It is always about earnings and interest rates, in terms of fundamentals. Corporate earnings growth this year will be up north of 40% from last year. The following year, 2011, we'll transition to earnings growth around 6% or 7%, which is more in line with the historical average. The Fed appears to be stimulative through the middle of next year, at least―and that is not only QE2. When the Fed reopened the currency-swap desk with the European Central Bank last May, that told me we are at near zero on the short end of the curve through the middle of next year.
What are you looking for the S&P 500 to earn?
Operating earnings for the S&P this year should be $82 or $83, and that is exactly what it did in 2007. Yet in 2007, the S&P traded at 18 or 19 times that number, and we discounted it at 400 basis points [four percentage points] on the short end of the curve. Today, we are at a multiple of 14, 15 times, and we are discounting it at zero. So that's a plus for investors. Looking into next year, however, I am alarmed because expectations are too high from a profitability standpoint. I look at consensus earnings estimates above $95, and I'm not there. I'm in print at $87.50 for 2011, and that may be too conservative. But even if I tweak it, I don't see myself going above $90. We are in a liquidity-driven market, but we should be mindful that there are many fundamental risks that could bring that $95 number down closer to $90.
Presumably, that would put a lid on any upside.
Yes. Again, we are at the top end of my trading range as far as the S&P 500 goes. At the same time, there is a fundamental risk with some corporate profitability for next year. I think the economy will grow in the 2%-2½% range in 2011. We should still have 9% unemployment by the end of 2011. And looking at these sovereign-credit spreads in Europe, it seems that we are just ignoring them right now. It is convenient to ignore, because everything else seems to be going well, with all the positive news we got recently. But investors should be mindful of that going forward.
You sound pretty upbeat, but what's the outlook for housing and employment?
We are in the process of finding a floor in housing and a ceiling on the unemployment rate. And if I had to pick one, I think we will be more successful at finding the ceiling for the unemployment rate. It doesn't appear, with 151,000 jobs created last month, that we are going to see a significant increase in the unemployment rate. So we've pretty much established that ceiling. As for a floor in housing, we are starting to see marginal improvement on a year-over-year basis. But we have not quite fully established the floor. So those are the two key points, and that will obviously have an impact on income growth, which translates to consumption growth, and then we'll see how that can really power gross domestic product higher next year. And I suspect it will be a less spectacular expansion.
You use technical and fundamental analysis. How do you balance the two?
For the first 23 years of my 25-year career, I was an unrepentant fundamentalist, focusing entirely on earnings, interest rates, top-line growth, inflation, price-earnings ratios―you name it. Ever since September 2008, you can call me a battlefield convert. I started checking out the charts. What we try to emphasize to our advisor partners and to our clients is to look at how we've attempted to combat this financial crisis. We've printed tons of liquidity, companies have gone under, and companies have bought back shares. Essentially, we've had more dollars chasing fewer shares, so that's made it a liquidity-driven market.
That makes it important for investors to have a better appreciation for support and resistance. And when I say the top end of the range for the S&P 500 is that 1250 area, a real key number, in my mind, is the 1228 level, which represents what is known as the 62% retracement to the October 2007 high. It's at that 1228 number where a lot of institutions may start pulling out of equities, just as individuals start jumping in. And for those reasons, we have to appreciate the technicals.
Are you more worried about inflation or deflation?
I am sure that Milton Friedman is spinning in his grave, thinking of all the money we've thrown at this problem. And when I see another round of quantitative easing, this one totaling $600 billion, I'm not convinced we really needed that. However, the Fed has done all it could, and I think Bernanke acted admirably. I'm disappointed in the fiscal leadership, though. We've had a year to determine whether tax rates on dividends and capital gains would be extended at current rates of 15% or if they would be extended at, say, 20%. We need the fiscal leadership. If we do get it, I could see myself raising my fair-value estimate for year-end 2011. But it really comes down to that fiscal leadership. As for inflation/deflation, when the unemployment rate doubled and when house prices fell 40% from peak to trough and when the price of oil went from $150 to $50 a barrel, in my mind that was a deflationary experience. But when you throw trillions of dollars at a problem, ultimately there is going to be some inflationary buildup. The Federal Reserve Bank is making a mistake now by focusing on lagging inflationary indicators like the core personal consumer expenditure index. If we just look at what the Treasury yield curve is telling us, we should see slow growth with a potential for a small uptick in inflation over the next 12 to 18 months.
How sustainable is this stock-market rally?
It could get tired real soon. Technical strength could get us to north of 1250. If we get a two-year extension of the existing tax rates on capital gains and dividends�and they are talking more and more about doing that―we could blow through 1300 on the S&P. And that's when I get really scared. I'm in an uncomfortable position of being an equity strategist and being scared, because there would be too much air underneath the market.
So as we get to the top end of this range for the S&P 500, it really comes down to active management. It is not a passive game, and that is something we advise our partner advisors and our clients about�that is, in this environment be tactically strategic or strategically tactical. An active diversification strategy whereby you can take some money off the top and rebalance your portfolio when the S&P 500 is in the 1250 range makes sense. Also, we are still mindful of what is going on in Europe, the high unemployment rate in the U.S. and the deleveraging. The consumer is not done there yet.
What stock sectors look attractive?
I favor a slight overweight of U.S. large- caps, relative to small-caps. Large-caps have the valuation attraction. They also have the international exposure that small-caps don't, and a lot of large companies can fund their future growth internally. Another reason why we see less spectacular economic growth next year is that the credit availability in this cycle is not what it was in previous cycles, when the non-deposit-taking institutions, such as hedge funds, pension funds and some brokerages, were participating. I also think there will be some takeover candidates among some well-run small companies.
Lynch's Sector Picks
| Sector | Recommendations |
| Technology | Overweight |
| Energy | Overweight |
| Industrials | Overweight |
| Materials | Overweight |
| Utilities | Neutral |
| Telecom | Neutral |
| Financial Services | Neutral |
| Health Care | Neutral |
| Consumer/discrectionary | Underweight |
| Consumer/staples | Underweight |
| Source: Wells Fargo Funds Management | |
What about growth versus value?
I am agnostic when looking at growth and value on a valuation basis. Growth has really outperformed these past three months and, from a relative value standpoint, we are basically at historical averages. If we had to give a bid, I would take growth over value, purely from a top-line view, and also looking at some of the leading growth companies such as Oracle [ticker: ORCL], Cisco Systems [CSCO] and Microsoft [MSFT]. What do they have in common? They're offering or planning to offer a dividend yield, and I have never said that in 25 years of doing this. For growth to succeed, it is going to be more of a Graham and Dodd type of return, with earnings and income.
In addition, I'd overweight emerging markets, relative to developed markets. First, the developing markets weren't as leveraged to the extent the developed markets were. Emerging markets have growing populations. Some also are resource-rich and have export-driven economic models that are prime beneficiaries of global stimulus plans. They have consumer-utilization rates for a variety of consumer goods at ridiculously low penetration rates. I would be at least 60%-40% in terms of emerging versus developed equities.
What about U.S. sectors?
We are recommending an overweight in technology, which certainly has rallied the past couple of months. But on a year-to-date basis, tech stocks are not where they should be; you have a great earnings-growth opportunity in that sector. And we are still at an overweight for energy. With oil around $85 a barrel, the consensus earnings projections are low for 2011. Also, in line with the global stimulus plans, I suspect you'll see continued gains for industrials and materials.
Which sectors have you underweighted?
The consumer. I think we are overestimating the consumer's ability to continue to drive the economy. On the staples side, I'm concerned about all the price increases in commodities. That is obviously going to chip away at the margins of many classic staples companies, such as Procter & Gamble [PG] and General Mills [GIS], both of which have cited increased commodity costs in their recent earnings and outlooks. As for the discretionary side, we are close to a bottom in housing, but we're not there yet. And if businesses hire along the lines they did in October, that's barely going to be enough to keep in front of population growth.
Which sectors are you neutral on?
I love the cash situation for health-care companies, many of which have strong balance sheets, but I won't overweight them because we are still trying to figure out the impact of the new regulations. The same thing is true with financials. Everybody is still trying to figure out what the new financial legislation will mean for a variety of industries within the sector.
I'm also neutral on utilities and telecom, though I love the dividend opportunity in those sectors. And again, if we can get clarity on fiscal leadership, we could probably see a further pop in those areas. But we have to be mindful that with telecom, for example, you still have regulatory risks. You have the costs of building out bandwidth. As for utilities, it looks like cap-and-trade legislation is off the table. But there still may be some sort of regulatory risks in the utility sector, as well. So you have yield as an attraction for telecom and utilities, but you have some potential legal or regulatory headwinds.
Thanks, John
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