STOCK MARKETS : STEAMING AHEAD / BARRON' S MAGAZINE COVER

BARRON'S COVER - MAIN

Steaming Ahead

U.S. equities could head higher in coming months, propelled by strong earnings gains and low interest rates

By VITO J. RACANELLI

September 6, 2014

Expect the bull to stay in charge for the rest of this year, and likely well beyond. That's the collective and decidedly upbeat view of the 10 top stock market strategists Barron's recently surveyed to gauge the investment outlook for the months ahead.

The Standard & Poor's 500 stock index already has rallied 8.6% year to date, to a record high of 2007.71, surpassing the mean target of 1977 our panelists forecast last December. Add dividends to the mix, and the total return is 10.1%. Based on the strategists' current mean year-end forecast of 2030, the market could rise another 1% before the curtain comes down on 2014. And that's after last year's blistering 30% advance.


Scott Pollack for Barron's

None of the group, whom we survey each September and December, is bearish these days, although some strategists have toned down their optimism because of the market's gains. Still, the most bullish see the benchmark barreling toward 2500 in the next 18 to 24 months. That would be an increase of nearly 25% from last week's close.

Earnings drive stock performance, and the outlook is relatively rosy here, too. Our 10 savants expect S&P 500 earnings to rise 7% in 2014, to a mean $117.83, after advancing 5.7% in 2013. They look for earnings growth to accelerate to 8.1% in 2015, for a total of $127.34. Industry analysts' forecasts, as usual, are even more upbeat than those of the big-picture crowd, at $119.31 for this year and $133.49 for next, according to Yardeni Research.

THIS YEAR'S STOCK MARKET RALLY owes chiefly to rising corporate profits, as well as a modest increase in the market's price/earnings ratio. Most strategists expect profit gains to remain the primary driver of equity performance, and see little multiple expansion ahead. The S&P 500 currently trades for 15.8 times analysts' consensus earnings-per-share estimates for the next 12 months, up from 15 times at the start of 2014. Today's P/E is slightly above the market's long-term average forward P/E, also 15, but below the P/E at previous peaks.

Compared with equities around the world, U.S. stocks no longer are as undervalued as they were 12 months ago, in part because of improving corporate fundamentals. But they are downright cheap relative to U.S. Treasury bonds, which have rallied mightily and currently sport historically low yields.

Although the bears' ranks have thinned considerably as stocks have pushed higher, some strategists don't rule out a market stumble in the year's final trimester. Yet, they expect any selloff to be limited by the "buy on dips" sentiment evidenced earlier in the year. Our prognosticators don't see a correction -- traditionally defined as a decline of at least 10% in stock prices -- in the offing, although the possibility worries many other investors. After all, the market hasn't seen a drop of that magnitude since 2011.

What might end, or at least interrupt, Wall Street's long-running party? The prime candidate is the looming conclusion, perhaps as soon as October, of the Federal Reserve's monthly bond-buying program, known as quantitative easing. QE was aimed at keeping interest rates suppressed and spurring economic growth. Its finale will remove an important support for the equity rally of the past few years.

Additionally, investors have been keeping a watchful eye on political tensions around the globe, especially in the Middle East and Ukraine. A worsening picture in either place could undermine investor confidence. Likewise, investors would be rattled if the European economy slipped back into recession, despite recent easing actions by the European Central Bank. Then, there's the calendar; September and October historically have been the worst months for the stock market.


OUR PANELISTS GOT MUCH RIGHT about 2014, based on the forecasts they put forth in December for the economy and the market. But, like almost everyone else, they were spectacularly wrong about interest rates. Their general call for rates to rise sharply this year has been upended by a slide in the yield on the 10-year Treasury bond to 2.46% from 3% at the start of the year.

Yet, even after the ferocious rally in bonds (bond prices move inversely to yields), strategists persist in calling for Treasury yields to rise by the end of this year; their mean forecast for the 10-year yield is 2.89%. If they are right, however, the ensuing drop in bond prices could rattle the stock market. This time, at least, the strategists acknowledge that the rate consensus could be misguided, as there are strong global forces still keeping a lid on U.S. yields. More about that in a moment.

For a pleasant change, the political climate in the U.S. no longer seems such a pressing concern to Wall Street. That's because party warfare over issues such as taxation, the federal budget deficit, and the debt ceiling has diminished in ferocity, at least temporarily.

Moreover, the Street's strategists don't envision that the results of November's midterm election will bring much change to the balance of power in Congress. Debate about issues such as corporate tax reform and immigration policy, which might otherwise contribute to market volatility, is likely to be pushed to 2015 or 2016.

Good news about the U.S. economy, too, could lead to higher stock prices. Second-quarter growth of 4.2% in gross domestic product indicates the economy is finally starting to boost itself out of its low orbit, after expanding by an uninspiring 2% or so year-on-year in the previous five quarters. Moreover, an 11.7% rise in second-quarter S&P 500 profit, and a 6% jump in quarterly revenue per share, have gladdened many bulls.

IF THE ECONOMY CONTINUES to strengthen, capital spending will rise. Small wonder, then, that many strategists call information technology and industrials their favorite S&P sectors for the rest of the year. Tech is universally loved by our forecasters, and has been for several years. It is the third-best-performing sector year to date (see table below).


Similarly, strategists favor cyclical sectors over defensive sectors, which include utilities, telecommunications, and consumer staples. Utilities and telecom are considered bond proxies and would be hurt if interest rates rose, while consumer staples have above-market P/E multiples and aren't leveraged to economic growth.

Utilities also won little love from our experts in December. But they confounded the bears by outperforming all else in the first half of 2014 as bond prices rallied and yields fell. Here's a closer look at factors likely to shape investors' behavior and the market's performance in the final stretch of 2014, and beyond.

Valuations

Our panelists view U.S. stocks as neither cheap nor expensive, considering the low level of interest rates. "Stocks offer less compelling value than a few years ago," says Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America Merrill Lynch. "But if anything, there's an upside risk to my view" that the S&P 500 will end the year around 2000.

Macroeconomic data are improving, and profitability is broadening out, she notes, with every S&P sector exhibiting earnings growth in the second quarter. At the same time, the market's price-to-book-value ratio and corporate debt levels are modest compared with prior market peaks (see table below).


There is plenty of cash on the sidelines, and investors' equity allocation remains conservative, says Subramanian. "The market is supported by a 'buy on pullbacks' mentality, and a pullback of more than 5% would be a surprise," she says.

Stephen Auth, chief investment officer of Federated Investors, concurs. His outlook remains among the most bullish, and his market views have been right on the money for the past two years. "The U.S. economy is accelerating and so are earnings," he says. "Institutional investors are underperforming. There is an energy renaissance in the U.S., and the housing market is doing well. The underlying fundamentals are really good."

AT THE SAME TIME, interest rates have been kept low by global economic and policy forces. "We're just exiting a 15-year bear market, with stocks effectively up roughly 30% since the 2000 high, or by about 2% per year," Auth says. The Nasdaq Composite hasn't made a new high since 2000, and "an entire generation of investors has been taught that what goes up must come down hard," he adds.

After the second quarter's bright showing, investors expect things to revert to "slow-growth mode," and they remain skeptical of the bull market. Auth views that as a bullish indicator. "People are seeing a rally and rollover, but I don't see the rollover," he says.

Auth expects the S&P 500 to climb to 2500 or so in the next 18 to 24 months. "Whatever correction we get will be short and shallow," he says.

He's an exception among his peers in arguing that the market's P/E ratio could rise to 17 times future earnings, at least.

New to our strategist lineup this fall is Jonathan Glionna, named head of U.S. equity strategy at Barclays in July. He replaces Barry Knapp, a former Barclays strategist who left the bank. Glionna has a year-end price target for the S&P 500 of 1975, and a target of 2100 for next year. He contends that the S&P 500 is "modestly expensive" at a current 15.8 times his 2015 earnings estimate of $127 a share.

The "recovery rally" has run its course, and returns from here could be "much more moderate," he says. The missing ingredient is revenue growth, which has been less than 3% a year for many S&P companies. Glionna anticipates that top-line gains will remain subdued because of weak domestic and international economic gains. While S&P 500 sales rose 6% in the second quarter, he ties that to sales activity pushed forward from a soft first quarter, when U.S. GDP contracted by 2.9%, partly as a result of severe winter weather around the country.

GROWTH REMAINS ANEMIC in Europe, Corporate America's second-most-important market, he says. Indeed, recession fears have been bubbling up again on the Continent, where second-quarter GDP contracted in Germany and Italy, and was stagnant in France. Absent higher revenue growth, market gains could track earnings increases, Glionna says.

Jeffrey Knight, head of global asset allocation at Columbia Management, also tempers his bullish view. "The U.S. stock market is pricing in prosperity, but prosperity seems to be applying to a shrinking subset of global markets," he says.

Japan isn't doing well, and a European slowdown won't help. "It's not clear that the U.S. can decouple from a global slowdown," says Knight, whose year-end target is the lowest among the 10, at 1950.

Interest Rates

David Kostin, chief U.S. equity strategist at Goldman Sachs, says the interest-rate outlook is the biggest risk for stocks. Economists currently expect the Fed to lift the federal-funds rate beginning around the middle of 2015. (The fed-funds rate, which the Fed has targeted at 0% to 0.25% since December 2008, is the overnight lending rate depository institutions charge one another to borrow money stored at the Fed.) Anxiety about higher rates usually rattles stocks, but in Kostin's view, it is hard to see a catalyst for a 10% correction. "Possible? Yes. Probable? I don't think so," the strategist says.

Adam Parker, Morgan Stanley's chief U.S. equity strategist, says the end of QE could usher in a more-volatile market, especially if it coincides with big reductions in analysts' earnings estimates. Wall Street analysts often mark down their numbers in September, as companies' full-year performance comes into better view, he says.

Russ Koesterich, BlackRock's global chief investment strategist, is expecting the market to weaken some this fall, but he does not predict a classic 10% correction. He maintains a year-end price target of 2025 on the S&P 500. Koesterich says evidence of robust U.S. economic growth could force the Fed to accelerate a "normalization of rates." An adjustment forward of expectations could produce heightened volatility, he adds.

Even if rate fears rock stocks this fall, other forces could keep a ceiling on Treasury yields, perhaps beyond late next year. The decline in bond yields in 2014 is a reflection of events beyond these shores, says Columbia's Knight. The political tension and violence sweeping other parts of the globe has ignited a flight to safe-harbor assets, U.S. bonds among them.


BEFORE YOU COMPLAIN that a 2.4% Treasury yield looks puny, compare that with the less-than-1% yield on 10-year German Bunds, and low yields across much of Europe. Comparable bond yields in Japan are even lower, at 0.5%. Such wide spreads have turbocharged the rush into U.S. bonds.

A change is unlikely in the near term, which could support U.S. bond prices, keep the pressure on yields, and buoy equities, says John Praveen, chief investment strategist at Prudential International Investments Advisers.

On Thursday, the European Central Bank lowered its main lending rate to 0.05% from 0.15%, and announced the launch next month of two new programs to buy asset-backed securities and covered bonds issued by euro-zone banks. In recent speeches, ECB President Mario Draghi has voiced fears about the stagnant euro-zone economy and signaled that the central bank was moving closer to large-scale asset purchases.

Japan, too, will have to expand its monetary-easing action, Praveen says. Put another way, the Fed will be passing the QE baton to other central banks. Even emerging-market countries are reducing interest rates.

The strategists all say Treasury yields eventually will have to rise and bond prices fall if the U.S. economic recovery continues on its current path. Still, yields could remain relatively low for a while, lending support to stocks, Praveen says.

Like Auth at Federated, Praveen consistently has been among the most bullish of our pundits. His year-end S&P 500 target also is 2100. The S&P's earnings yield -- or earnings divided by price -- is 5.6%, more than double the 10-year bond yield. Although not as cheap as they were nine months ago, "stocks are a screaming buy compared to bonds," Praveen says.

Market Sectors

Technology stocks once again are the darlings of stock market strategists, not least because tech companies are expected to produce the strongest growth in earnings per share. Mostly, that's because capital spending looks poised to expand.

Citi Research trolled through more than 700 company reports in recent months for management guidance from chief financial officers and the like. Its researchers found that capital-spending expectations appear to be moving up sharply, says Tobias Levkovich, Citi Research's chief U.S. equity strategist.

"Last December, the CFOs were expecting 1.5% capex [capital-expenditure] growth, which rose to 5% in March," he says. "That jumped to 6.8% in June. Capex is accelerating." CFOs in the tech sector were anticipating a 10% bump in capital spending.

Business investment has been unsteady in recent years, but second-quarter GDP numbers suggest that investment is improving, says Nuveen Asset Management's chief equity strategist, Robert Doll. Businesses sharply increased spending in the April-June period on buildings, up 9.4%, and equipment, up 10.7%.

The tech and industrial sectors were beneficiaries, says Doll, who likes Apple (ticker: AAPL) and Microsoft (MSFT) for their ample free cash flow and profits, and Hewlett-Packard (HPQ) as a turnaround play in the sector.

The U.S. tech sector is a leader in mobile, the cloud, and "everything that is exciting in tech," says Federated's Auth. Google (GOOGL) is one of his current picks, in part because it is just starting to monetize valuable assets. Also, while the shares trade at a market multiple, the company could enjoy a 20% gain in earnings per share this year.

BANK OF AMERICA'S Subramanian says an expected rise in bond yields could lead to losses in slow-growth, high-yield sectors such as utilities and telecom. Multiple expansion has been most pronounced in defensive shares, and as the market keeps rising, "you could see a trade-off," she says. Winning sectors, such as tech and industrials, could benefit from rising P/Es, while defensive names could experience P/E compression. Inexpensive and largely ignored big-cap tech names such as Cisco Systems (CSCO) could find themselves back in favor again, she says.

SMALL-CAPS HAVE HAD a dismal year relative to their larger cousins, with the Russell 2000, a popular small-cap benchmark, up about 1% on the year. Citi's Levkovich expects small-caps to continue to underperform. High-yield corporate-bond spreads have widened, and that typically isn't a particularly good signal for small-caps, he adds.

Nor is increased volatility. Besides, Levkovich doesn't expect smaller stocks to capture any improvement seen in global growth, given their relatively low exposure to international sales.

Investment Risks

Even the most bullish strategists acknowledge there are risks to the market that could undo their optimistic forecasts. A quick and sharp rise in U.S. Treasury yields would be most unwelcome by equity investors, and no one, including the governors of the Federal Reserve, knows how bonds will react when the central bank ends its purchases.

World growth is expected to accelerate, but Europe is teetering on the edge of another recession. Further ECB easing might not be enough to forestall a contraction in the euro zone's economy.

THE BULL HAS RALLIED while the Middle East has burned. However, a worsening of the political and military backdrop in that troubled corner of the globe could spook investors in the future, especially if hostilities threaten to disrupt America's supply of oil from the region. Domestic production of oil and gas has been soaring, but the stock market has never cheered a sharp spike in energy prices.

Tensions between Ukraine and Russia have been escalating all year, and things could easily get worse. Some pundits think this is Europe's problem, but flare-ups in the hostilities already have sent mild tremors through U.S. stocks. "Europe is a key area to watch," says Columbia Management's Knight.

If the region can pull out of the economic doldrums, the U.S. market could well profit from European growth. "If Europe can't, it begins to have an echo effect in the U.S.," he says.

Nevertheless, U.S. stocks appear to be the best-positioned asset class relative to U.S. Treasuries and global equities, according to Wall Street's top seers. The horizon is reasonably clear, they say, and it's steady as she goes.