BARRON'S COVER
Fall Outlook
By KOPIN TAN
Top strategists think stocks will make only limited progress between now and year end. Why they favor sectors like technology and energy over defensive havens such as utilities.
Top strategists think stocks will make only limited progress between now and year end. Why they favor sectors like technology and energy over defensive havens such as utilities.
THE 2009 RALLY HAS REPAIRED SOME of the portfolio damage suffered in the stock-market crash. Repairing confidence, however, is a different matter. Though stocks rebounded as much as 52% in the past six months, even Wall Street's most faithful constituents don't expect that momentum to last.
As autumn arrives, the 10 top strategists and investment officers surveyed by Barron's say they expect the Standard & Poor's 500 to finish this year at an average of 1056 -- barely 4% above today's level at 1016. To put this in perspective: After clocking monthly gains averaging 6.5% since March, the market is now expected to creep up less than 1% a month. Apparently, the fourth-quarter bounce has gone the way of the three-piece suit and the two-martini lunch. A Santa Claus rally? Maybe not this year.
No, the strategists haven't turned bearish. They are essentially bullish, even if their price targets are subdued. Nearly all of them think that lavish government stimulus programs have stabilized the economy during the worst recession in generations, and they expect operating profits of S&P 500 companies to rebound 24% in 2010. The majority heavily favor cyclical energy, materials and technology stocks, which usually thrive as the global economy mends. In contrast, no one likes consumer staples. And other defensive havens, such as health care and utilities, are roundly shunned.
Remarkably, our last survey, conducted this past December, called for the S&P 500 to finish this year at 1045. That puts our forecasters well on track for a bull's eye. Yet many of these vocationally bullish strategists have resisted the urge to nudge their targets higher, even as the S&P approaches, or surpasses, their previous marks.
The cluster of year-end targets between 1000 and 1100, all in a tight band within a short distance of today's market, reflects a common concern that stocks have already run up very far, very fast. Traders lunging at stocks at the first whiff of economic recovery have swelled price/earnings multiples. "A lot of good news is already priced into the market," says Larry Adam, Deutsche Bank Private Wealth Management's chief investment strategist.
Says Myles Zyblock, RBC Capital Markets' chief institutional strategist: "We've had the lion's share of multiple expansion, and we'll need earnings to grow to catch up. The market is digesting a lot of gains, and it won't take much to trigger a correction."
Last week, stocks pulled back 1.2%, even after data showed manufacturing expanding for the first time since January 2008. One red flag for this fall: Estimates by stock analysts for 2010 profits are still roughly 25% higher than market strategists' forecasts -- and the third quarter is when companies begin looking ahead to a new year and quashing improbable expectations, says Citigroup strategist Tobias Levkovich.
The expiration of the Federal Deposit Insurance Corp.'s term-loan guarantee for bank bonds, or any tax hikes to fund health-care reform, could rattle the market, he warns. In addition, companies were granted a reprieve from funding their pensions in 2009, and with only 21 companies within the S&P 500 sitting on fully funded retirement plans, the resumption of that obligation will eat into next year's profits.
Still, no one seems to think a correction will be anything but short and shallow. Most believe that the 12-year low seen in March, when the S&P 500 skidded to 676, will remain a "generational" threshold, and that the government's assertive policies have averted a depression and forced a revival that is beginning to resuscitate our economic indicators.
The restocking of depleted inventories, consumer-targeted incentives like cash for clunkers, and easier comparisons all invite economists to pencil in gross-domestic-product growth in the low single-digits in the second half and in 2010.
Nearly everyone acknowledges the looming threat of stringent taxation, and the toll that must one day be paid for today's financial-disaster relief. But no one expects the Federal Reserve to yank its obliging monetary policy before year end. The debate, in fact, is whether the government will wait until 2011 before raising rates again. And seven of the 10 firms in our survey expect Treasuries to stagnate and the yield on the 10-year to edge up from about 3.44% today.
SO, ARE THE EASIEST GAINS already behind us? We've seen the best six-month run since 1938, yet there are reasons, some overlooked by investors, why stocks could still work their way higher.
For a start, companies' profit margins are holding up well. Margins shriveled to about 4% during downturns in the 1980s and early 1990s, but recently troughed at 6%. Henry McVey, head of global macro and asset allocation at Morgan Stanley Investment Management, attributes the stronger margins to higher commodity prices during this trough, lower corporate taxes and a smaller debt burden. And with technology and health care making up 19% and 14% of the S&P 500's market cap, respectively, high-margin and less economically sensitive segments now drive a bigger chunk of the market.
"Higher relative margins endow Corporate America with more of a buffer against economic volatility than what Corporate Japan exhibited in the 1990s," McVey says. He expects S&P 500 multiples to stabilize or even expand, as return on equity rebounds to 14% in 2010 from the current 11%.
Replacing duds like General Motors with more robust companies on indexes also adds roughly $7 of earnings per share to S&P operating profits. Thanks to such changes, the S&P's book value per share has increased $40 from the market bottom, to about $495 -- and could rise further as profits swell.
"The key issue to focus on in the next four months is top-line revenue growth," says David Kostin, Goldman Sachs' chief U.S. strategist. Since peaking at $91 a share in mid-2007, S&P 500 profits have suffered the worst contraction since the Great Depression, falling 53%. During this stretch, companies have cut jobs, slashed fixed costs and amassed considerable operating leverage that can come in handy when revenue grows again.
Kostin thinks companies exposed to the faster-growing economies of Brazil, Russia, India and China are better positioned to deliver such growth. To that end, Goldman has flagged a basket of 50 U.S. stocks with the highest percentage of sales to these BRIC countries. The selection includes Sohu.com (ticker: SOHU), Marvell Technology (MRVL), Mylan Laboratories (MYL), Pfizer (PFE), Morgan Stanley (MS) and Yum! Brands (YUM).
Goldman's roster of 24 stocks with the greatest operating leverage includes Amazon.com (AMZN), Safeway (SWY), Pioneer Natural (PXD), Hess (HES), Grainger (GWW) and Applied Materials (AMAT).
Kostin's 1060 target for the S&P pegs the index at 14 times projected 2010 profits of $75 a share, and he thinks a multiple of 15 would be "reasonable" in a modestly growing economy. JPMorgan Chase strategist Thomas Lee says a forward multiple of 16 is typical six months into an economic expansion; his target of 1100 is just 14.7 times his projected 2010 profits. The group forecasts S&P 500 companies will earn a weighted average of $72 a share next year.
THE MOST BULLISH CALL in the Barron's survey comes from John Praveen, who sees three catalysts propelling the market another 16%, to ring in the new year at 1175. "The recovery from the global recession is stronger and faster than expected, earnings expectations are being revised upward, and we're entering the inflation sweet spot," says the chief investment strategist at Prudential International Investment Advisers. "Deflation fears are receding, yet inflation is not yet picking up. So corporations have pricing power, but central banks aren't going to raise rates just yet."
Christopher Hyzy, U.S. Trust's chief investment officer, also thinks "growth could prove higher and inflation lower than the consensus forecasts." The recession and credit crunch created the most slack of any downturn since World War II, with a third of our industrial capacity idle, and Hyzy believes prices of goods could stay low even as sales volume starts to pick up. "Because of the affordability of durable goods, consumers can de-lever and still spend enough for sales to grow nominally," he says.
Hyzy sees "a great convergence" of the shorter-term repair-and-recovery phase with the longer-term shift of economic growth from developed to developing worlds. Steadily improving confidence and near-zero interest rates on cash will support prices of assets, including equities.
SO WHAT ARE WE WORRIED ABOUT? For openers, increased regulations, higher taxes, vexing unemployment and the inevitable "exit strategies" through which central banks will begin to withdraw liquidity.
McVey of Morgan Stanley flags three key risks ahead, starting with the price of oil. When inflation fears are afoot, higher commodity prices are embraced as a welcome sign of healthy global demand -- "but above $85 [a barrel], I think rising crude oil prices go from being a positive to negative." Anything that diminishes the currently steep -- and lucrative -- yield curve will rattle the market, as can any fundamental shift in global policies toward protectionism, or away from the collective support of global growth.
The swing in investor sentiment also bears watching. "The word 'depression' crept into our vocabulary regularly just a few months ago," says Robert Doll, BlackRock's global chief investment officer. "Has our world changed so completely we're now focused primarily on earnings growth? Have companies' balance sheets really improved that thoroughly?" Among Doll's concerns: Banks haven't set aside enough to cover losses in consumer loans, credit cards, autos and commercial real estate, and he remains wary of financial stocks. Levkovich also warns about commercial real estate, especially real-estate investment trusts, which have doubled from their March lows. He cites rising vacancies and a supply glut.
Barclays' equity strategist, Barry Knapp, has the lowest target; he expects the S&P 500 to pull back 8.5% to end the year near 930. Stocks' summer rally coincided with falling real rates, "which implies a slight marking down of growth expectations," he cautions. Meanwhile, bank loans and leases have shrunk 4.9% this year. The yields of lower-risk asset classes and agency mortgage-backed securities have risen slightly this summer, versus those of comparable-maturity Treasuries. Knapp views this as tied to the winding down of the government's massive quantitative easing program (read, money printing). "If the recent spread widening continues into September, we doubt that U.S. equities will remain unscathed."
Although leading economic indicators are turning higher, with home prices rising for the first quarter since 2006, worries remain that the economy will fall into a double-dip recession.
Then there are the well-articulated fears about muted consumer spending. The U.S. savings rate dipped to 4.2% in July from 4.5% in June, chiefly as the cash-for-clunkers program boosted car purchases, but most economists expect it to resume climbing toward 8% next year. And every one percentage-point rise in savings reduces growth by 0.7 percentage points.
Investors are "naturally worried about a languishing consumer," says JPMorgan's Lee. However, frugal spending is typical after a recession. In fact, in three out of every four recoveries, consumer spending has lagged behind overall GDP growth in the first nine months, and the firm's economists expect consumer spending to grow 2%-3% through 2010 while the economy expands at a 3%-4% pace.
The unprecedented credit crunch and market meltdown led to an unprecedented level of government stimulus, and now "we're experiencing an unprecedented rally that I feel isn't yet complete," says Michael Hartnett, Bank of America Merrill Lynch's chief global equity strategist. Merrill has a 12-month target instead of a year-end one, and isn't included in our survey.
Ahead lies a possible "moment of truth," Hartnett says. "Will attempts of policy makers to stimulate the economy lead to a virtuous cycle of growth, even if that growth is slow? Or will it fail because no matter the short-term incentive, consumers will worry about the eventual cost of that stimuli and decide not to spend?" Besides the usual consumer barometers, Hartnett is also watching President Obama's approval ratings as a gauge of consumer confidence.
JUST HOW CROWDED IS THE BET on cyclical stocks? Global-growth beneficiaries like technology are favored by no fewer than eight strategists, energy by seven and industrials by six. Strikingly, not a single expert suggests shunning energy, industrial, materials and technology issues, even though some of these have already risen substantially; tech and materials stocks are up 39% and 31%, respectively, this year.
That stellar run and the by-now-familiar argument in their favor is why BlackRock's Doll advocates a "barbell" portfolio, balancing cyclical and defensive stocks. "I believe the recession is ending, and we can't ignore the cyclical upside," Doll observes. "But cyclicals have run up hard, especially low-quality stocks, and I want some defensive quality in my portfolio." His picks: energy and health care.
In fact, McVey asserts that our recent lunge at economically sensitive stocks will eventually give way to "the revenge of the establishment." This means that established leaders will brandish their pricing power to crowd out smaller players and pad their market shares.
The familiar constraints on discretionary spending -- stagnant wages, decimated wealth, and those staggering credit-card balances -- have all but one strategist giving up on the consumer. "Consumer discretionary offers one of the more direct ways to capture stabilization in the housing indicators and peak in unemployment insurance claims," says RBC's Zyblock, who singles out media as a beaten-down, heavily shunned sub-sector whose earnings are starting to improve. Boding well for that sector, marketing will be stepped up in 2010 for the World Cup, the Winter Olympics, the World Expo in China and the midterm elections, adds Deutsche's Adam, who is underweight consumer stocks but favors media issues.
"Coming out of a recession, you tend to see a boost in media and advertising spending, with companies spending more to drive sales," Adam says.
Zyblock also likes financials, even though many banks are still struggling. They're "the best direct play on receding system-wide stress, the pickup in capital- markets activity and an upturn in financial assets," he says. Financial stocks are up 13% this year but remain at the low end of their 30-year valuation range, and a steep yield curve further pads the spread-lending business. Commercial real estate could "remain problematic" for many regional banks, but the bank index is turning up from cyclically depressed levels, he adds.
Health care, meanwhile, is bogged down with worries about pending reforms, and Adam calls it the sector with the most attractive valuation. "In the end, we'll most likely see a watered-down reform package that offers coverage to more people, but margins aren't going to collapse as much as people fear," Adam says.
He thinks a greater emphasis on preventive medicine will increase testing and benefit the laboratory, equipment, medical-service and pharmacy-benefits management groups. That should help health-care shares push higher as uncertainty lifts. With any luck, the market, too, will work its way up through the end of the year.
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