Which Way Up?
Stocks were pounded in August, but most market strategists expect them to rally this fall as the economy expands.
Few expected Hurricane Uncertainty to wallop financial markets last month, after U.S. stocks had risen 23% from Labor Day 2010 to July. Yet, as worries intensified in August over the possibility of a second U.S. recession and worsening debt problems both here and in Europe, the Standard & Poor's 500 fell nearly 18% -- almost enough to land the popular benchmark in bear-market territory.
Although the S&P has since come back from the brink -- the index closed Friday at 1174, up 5% from its Aug. 8 low -- the rally is fragile and investor confidence shaken. But many Wall Street strategists and money managers still are bullish about the outlook for stocks, and expect the S&P and its fellow market measures to head higher from here.
Barron's recently asked 15 investment strategists at brokerages and money-management firms to forecast the S&P's level at year end. The average of their expectations is about 1300, 11% higher than the market's current level and just 3.7% below their mean view before the August selloff.
Although Europe's sovereign-debt woes and concerns about China's growth are weighing on investors, the battle between the bulls and bears most likely will center this fall on the U.S. economy -- specifically, whether it continues to expand or "double dips" into another recession. Worries about a recession were exacerbated last month when the government lowered its estimate of second-quarter growth in gross domestic product to an annualized 1% from a prior estimate of 1.3%. Friday the market took another tumble after the Labor Department reported no new job growth in August, the worst report in 11 months.
IF, AS THE BULLS EXPECT, economic data stabilize and then improve instead of worsening, "the removal of double-dip fears takes us well into the 1250-1350 range" on the S&P 500, says Barry Knapp, head of U.S. equity portfolio strategy at Barclays Capital. Given the severity of the market's August decline, a reversal in sentiment could presage a fast and strong fourth-quarter rise for stocks, he says. Besides, after its latest bruising, the market is a lot less expensive than it used to be.
"Investors have been working in the shadow of extreme uncertainty…and the market is pricing in more than a recession," says David Kelly, chief market strategist at JPMorgan Funds.
Yet Kelly, who is bullish, notes that July data on manufacturing, retail sales and leading economic indicators all showed improvement over June's numbers, suggesting the economy isn't on the verge of another dip. He is looking for GDP growth of 2.1% in this year's second half, and an increase of 2.6% in 2012.
"The stock market is an engine flooded with liquidity but without a spark," Kelly says. When the "risk on" trade returns, consumer discretionary, technology and other growth-oriented sectors will do best, he adds.
John Praveen, chief investment strategist at Prudential International Investment Advisers, predicts fears of a double dip will ease in the next few months. He expects the economy to grow by 2.9% in the second half of 2011, and by 2.3% next year. "We're looking for a bounce [in stocks] once people get confidence in those numbers," he says.
Michael Ryan, who has the same post at UBS Wealth Management Americas, sees "sloppy and choppy" trading, however, as investors sort through conflicting economic data. He expects the S&P to end the year at 1225. Ryan, who favors consumer staples and technology shares, thinks analysts' earnings estimates probably are too high. But "earnings aren't going to collapse," he says.
SHOULD THE STREET'S BULLS BE WRONG about the economy, the market could fall to 1000 or below, depending on the severity of the next recession. The few bears in our latest survey point to other disturbing statistics, such as the Philadelphia Federal Reserve's index of manufacturing activity, which dropped last month to its lowest reading since March 2009. The bears also worry about contagion from a potential European banking crisis; the possibility that both political parties won't agree on further deficit- and debt-reduction measures this fall, and the lack of jobs growth.
But few strategists, whether bull or bear, expect the Federal Reserve to take another bold step to stimulate the economy.
Among the bears, Douglas Cliggott, U.S. equity strategist at Credit Suisse, recently downgraded his year-end S&P target to 1100 from 1275, and his 2012 earnings forecast to $81 from $95. In recent weeks, he says, there has been a "stunning" deceleration in consumer confidence, which means consumers will be saving more and spending less.
Cliggott expects the slowdown to be met with fiscal tightening in the U.S., instead of monetary or fiscal easing, which typically have occurred during recessions. The props supporting earnings growth -- rising GDP, lower unit labor costs and a weaker dollar -- now have turned against higher S&P profits, he says.
Nor do technical signals support a higher market, says Jason DeSena Trennert, chief investment strategist at Strategas, who leans to the bear camp. The major indexes' moving averages have broken down, and shares of stocks closely tied to the direction of the economy, such as Advanced Micro Devices (ticker: AMD) and Sprint Nextel (S), have underperformed the S&P 500 sharply, he says. Trennert sees a difficult environment for economic expansion and a "35% probability" of a recession next year. "Nothing is happening that makes me bullish on the economy," he declares.
Trennert favors biotechnology, personal-products and utilities shares, such as Amgen (AMGN), Clorox (CLX), Colgate-Palmolive (CL) and Consolidated Edison (ED). He also thinks large-cap tech stocks such as IBM (IBM) and Microsoft (MSFT) will do well in an economy with little if any growth.
THE S&P 500 ENTERED THE YEAR with a price/earnings ratio of 14 to 15, based on strategists' earnings estimates for 2011. Now stocks trade for 13 times this year's consensus estimate of about $90, and just 11.5 times the $102 that S&P companies are expected to earn on a per-share basis in 2012. There is room for multiples to expand, especially as investors gain confidence in the economy's health, says Prudential's Praveen. He recommends buying health-care, consumer-staples, consumer-discretionary, industrial and technology stocks, and avoiding financial, materials and energy shares.
Investors need to put P/E multiples in context, says Binky Chadha, chief U.S. equities strategist at Deutsche Bank. For example, the S&P 500 is trading at 12 times earnings for the trailing 12 months ended June. This "almost exactly" matches the market's multiple of trailing earnings in March 2009, at the bottom of the bear market. "It was a much worse economic picture then…so the market is pricing in quite a lot [of bad news]," he says.
Chadha has a year-end S&P target of 1425, and thinks fair value for the market is 16 times trailing 12-month earnings. If a recession doesn't materialize, the multiple slowly will revert to fair value, he says.
Other metrics also suggest that equity valuations are comparatively low. David Kostin, Goldman Sachs' chief U.S. equity strategist, notes that when return on equity is 17%, the S&P historically has traded for 2.3 times book value. Its current book value of $611 is consistent with a price of 1400. Moreover, the S&P's current dividend yield, 2.2%, is above the 10-year Treasury bond yield, as it was in the teeth of August's panic. This traditionally has meant stocks are undervalued relative to bonds.
David Bianco, chief U.S. strategist at Bank of America Merrill Lynch, says stocks possess some of the most undemanding dividend metrics in a long time. The S&P non-financials hold $1.1 trillion in cash, equal to 12% of their market capitalization. Given today's low interest rates, he argues, companies could better maximize shareholder value by issuing long-term debt to buy back stock or increase dividends.
Another bullish sign is that the S&P's earnings yield -- the inverse of the price/earnings ratio -- now exceeds the average yield on investment-grade corporate bonds by extreme levels that in the past have been followed by stock-market outperformance, according to a recent JPMorgan report.
The equity-risk premium relative to bonds will be reduced as clarity emerges on the economy, says Goldman's Kostin, who expects to see the market's P/E rise to 13 to 14 times forward earnings within the next 12 months. Kostin advises investors to seek companies with high returns on equity, good dividend growth and exposure to emerging markets, such as ExxonMobil (XOM), Occidental Petroleum (OXY), railroad operator CSX (CSX) and Eaton (ETN).
P/E MULTIPLES ARE ONLY AS VALID, of course, as the earnings estimates that support them. And corporate earnings are the topic about which the Street's bulls and bears most disagree. The bulls see earnings rising on continued economic expansion. As Deutsche Bank's Chadha notes, corporate profits rose 17% to 18% in the first half, while GDP growth was only 0.7%. Companies have boosted earnings through cost cuts, and many S&P components generate a substantial portion of revenue in the faster-growing overseas market.
On the bears' side of the aisle, Credit Suisse's Cliggott, as noted, sees earnings of $81 next year, down from his 2011 estimate of $96. The prospective drop is consistent with his forecast for diminished GDP growth, a stable or rising dollar and a 2.5% rise in unit labor costs. If revenue growth decelerates, however, or profit margins contract, earnings could fall below $80 next year, and possibly to $70, he says.
Applying a multiple of 12 to $70 earnings would put the S&P 500 at 840, something "well within the realm of possibilities within the next 18 months," Cliggott says.
Though S&P earnings have returned this year to their prior peak, the index hasn't, he notes. In fact, it is 25% below its 2007 high. Cliggott recommends overweighting defensive sectors such as health care, staples, telecom and utilities, but he thinks financials look expensive. One cyclical sector that could hold up relatively well is tech, he says.
BULLISH AND BEARISH STRATEGISTS both will be keeping a close eye on Washington this fall, and they expect stocks to react, possibly in a volatile way, to any news about the progress of the Congressional Joint Select Committee on Deficit Reduction, which has been charged with finding at least $1.2 trillion in additional deficit cuts by Nov. 23. The on-again, off-again debate between both political parties that produced a debt-ceiling agreement this summer had a punishing effect on market sentiment in the U.S., and an unnerving one on markets around the world.
"Now we are looking at three months of uncertainty" in an already contentious battle, says Strategas' Trennert.
Robert Doll, chief equity strategist at BlackRock, expects that "the market will like any decent news" suggestive of bipartisan progress toward the avowed goal. His favorite stocks, given this backdrop, include health-care companies such as Aetna (AET) and Pfizer (PFE), and technology concerns such as Applied Materials (AMAT) and Microsoft.
With the stock market whipsawed, economic growth uncertain and worries abounding about markets overseas, many investors have sought refuge in U.S. Treasuries. Consequently, yields have collapsed, and prices have risen. Many strategists now consider Treasury bonds a "crowded," or excessively popular trade, with little upside remaining.
Viewed another way, there is plenty of cash now stashed in bonds that could find its way into stocks as conditions change and investors regain their confidence. "Just a hint of economic stabilization will send money flows from Treasuries to equities," says UBS' Ryan.
If Wall Street's strategists are correct, the shift could happen even sooner than many think
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