Scott Pollack for Barron's


For the first time in years, there’s dissension in the ranks of the Barron’s strategists.
 
Their consensus outlook for U.S. stocks in the remainder of 2016 is mixed and even tinged with a bearish hue. That represents a downgrade from the cautious optimism seen last December, ahead of the coming year.
 
Their mean expectation for the Standard & Poor’s 500 index is 2138 at year end, below Friday’s close of 2180. Four strategists call themselves bullish, three are in the bear camp, and three are neutral.
 
In this tug of war, the bulls say the combination of global central bank easy-money policies, improved earnings-per-share growth in the second half, and the continuing search for yield should lead to a happy ending in 2016. The bears, however, contend that rising election uncertainty, a Federal Reserve eager to boost rates, and the market’s high price/earnings ratio could make the rest of 2016 volatile.
 
With few exceptions, the 10 prominent seers we regularly consult each September and December for an equity-market outlook tend to be an optimistic bunch. In the recent past, the majority often looked for double-digit annual market gains, albeit with the odd bear dissenting.

Since this bull market—now the second-longest in history, after that of 1987-2000—sprang to life in March 2009, that has been a winning call.
 
Downright gloomy these strategists aren’t, and some of the pessimists still look for the market to revive modestly in 2017. But you’d have to go back to the bad old days of 2002-03 to find lower spirits in our biannual polls.
 
Late last year, the strategists’ mean expectation for the S&P 500 was 2220 by the end of 2016, 10% higher than the key index’s level of 2012 at that time (“Stock Market Outlook 2016,” Dec. 12). While not that bad a prediction, about half of them trimmed their forecasts during the market’s January-February swoon, bringing the consensus forecast down to 2105 in February.

At one point that month, the S&P slumped to 1810, down 15% from the previous high of May 2015, and 75% of the way to a bear market.
 
THE STRATEGISTS’ INDIVIDUAL 2016 year-end targets for the S&P 500 range from 2000 by two participants to 2300 by John Praveen, chief investment strategist at Prudential International Investments Advisors, now the most bullish pundit in this survey.

                                   
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In interviews last month, we also found an unusual divergence of opinion on another important front: the potential for a rebound in corporate earnings growth in the second half of the year, after drops of 5% in the first quarter and about 3% in the second. The majority expects profit gains to improve, but some believe that has already been incorporated into the S&P 500’s 19% rally from its February lows.
 
The average of strategists’ earnings-per-share estimates for the companies in the S&P is about $119 in 2016, down from a projected $123.50 last December and $129 in September 2015. That isn’t very different from the bottom-up industry analysts’ consensus of about $118, which is down from $132 some 12 months ago.
 
The market’s price/earnings ratio has risen markedly, to 18.5 times the bottom-up consensus EPS for 2016 of $118. That’s up from the respective P/E of 16.1 times the then 2015 EPS consensus of $119, twelve months ago. The lower EPS estimate, combined with a market up about 14% since then, are responsible for the higher P/E. Few strategists see the P/E expanding further without a reacceleration in EPS.
 
The S&P 500 hit an all-time high of 2190 last month, after being range-bound just below its old peak for more than a year. The Dow Jones Industrial Average reached a high of 18,636 on Aug. 15.
 
Where do our strategists agree? Most expect Hillary Clinton to win the U.S. presidential race. They also think that the Fed will raise rates in December, not at its Sept. 20-21 meeting, and that oil prices have at least stabilized. Chinese growth worries have dissipated, for now.

Perhaps most important, a majority also believes that, among global equities, U.S. stocks remain the place to be, given their relative safety versus foreign shares and riskier bonds, plus their relatively good profits in a slow-growth world.
                                  
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They also agree that corporate earnings will probably stop going down beginning this quarter, after six consecutive quarterly drops, mainly as energy stocks begin to lap their disastrous 2015 declines.
One new wrinkle in their calculus for the market this year is the potential for fiscal stimulus in the U.S., given that the country will hold elections just two months from now. Apart from an earnings rebound, the possibility of tax cuts—which would be a catalyst for the market—can’t be ignored, even if not every strategist thinks such a move is in the offing.
 
IF THERE’S ONE CLEAR agreement in this survey, it’s that the Democratic candidate is positioned to win the presidency and that such a scenario is the less-bad one for stocks. “Given where the poll numbers are, the market is comfortably expecting Clinton to win,” says Tobias Levkovich, the chief U.S. equity strategist at Citigroup’s Citi Research. He has an S&P 500 year-end target of 2150. Clinton’s policies might hurt one or another sector, such as pharmaceutical stocks, but they are largely known and that means less uncertainty. “It’s status quo, or a third Obama presidential term,” Levkovich maintains.
 
AND IF THE REPUBLICAN candidate wins? It could be Katie, bar the door—at least at first. There might be an immediate 3% to 5% knee-jerk downturn, the Citi Research strategist says.
 
Donald Trump’s reputation for shooting from the lip raises anxiety levels for investors, who ordinarily would be expected to plump for a more conservative and business-friendly GOP candidate. “Trump is hard to handicap because he has revealed so little in the way of policy,” says Jeffrey Knight, co-head of global asset allocation at Columbia Threadneedle. He has a year-end S&P 500 target of 2200.
 
Moreover, Trump’s comments on immigration and trade protection are viewed as unfriendly to the markets.

On the positive side, there might be an increased likelihood of a profit-repatriation holiday for U.S. companies, which are holding some $2 trillion in cash overseas, something Trump supports. But that’s probably not enough to outweigh the Goldilocks scenario: a Clinton presidency with the Republicans retaining at least the lower house in Congress.
 
Investors shouldn’t ignore the congressional races, either, say our strategists. Ironically, while tax reform is a key priority for business, continued government gridlock is often preferred by investors for its lack of surprises. Should a Clinton win be accompanied by a transfer of power to the Democrats in both houses of Congress, fear of higher taxes and stiffer regulation would also probably lead to a market correction.
 
OUR LATEST SURVEY comes two weeks ahead of the Sept. 20-21 Federal Reserve Open Market Committee meeting, and if there’s one thing that our strategists—and investors in general—got wrong this year, it was the pace of interest-rate increases. Think back to last December. The Fed was embarking on a normalization of rates, raising the federal-funds rate to 0.25%-0.50% from a longstanding 0%-0.25%.
 
The fed-funds rate—the overnight lending rate that banks charge one another for funds maintained at the central bank—helps shape the short end of the bond-market yield curve. Monetary stimulus in the form of Fed asset-buying and ultralow interest rates has been an important catalyst for higher stock prices in this lengthy bull market.
 
It’s perhaps hard to believe now, after the market swoon of 15% from all-time highs in the first part of the year and the United Kingdom’s surprise vote to leave the European Union, but last December investors expected the Fed to push rates up to 1% or more this year. As it happened, there have been zero increases in 2016, leading to the “lower for longer” prediction by bulls about rates.
 
“The strategic surprise of the year,” adds Knight, is that the Fed seemingly has moved to a more gradual rate-hike path from that expected at the end of 2015. In the face of the market volatility early in 2016 and Brexit, “the Fed blinked.”
 
“More like lower forever,” quips Stephen Auth, chief investment officer at Federated Investors, referring to the central bank’s rate strategy. Given global deflationary trends and a world in which many important economies, including that of the U.S., haven’t enacted the structural reforms necessary to return to expansion, Auth observes, “we are in an environment where rates are unlikely to reach past cyclical highs.
The Fed is handcuffed.”
 
Once our most optimistic forecaster, Auth has pulled in his horns temporarily. His year-end S&P 500 target currently is 2100. Last December, his prediction was a robust 2500, but in February he cut it to 1850. Now, Auth has pushed out his 2500 target to year-end 2018. “What’s changed is our view that U.S. and global growth would reaccelerate. That’s off the table,” he says. China’s economy is expanding relatively slowly; Brexit has raised concerns about European growth; and the U.S. is just plain slow, he notes.
 
Economists at the 10 institutions in this survey expect an anemic 1.7% U.S. expansion this year and not much better in 2017. “The growth picture isn’t great, but it’s healthy enough. Earnings will grind it out,” adds Auth.
 
The fear among bears in this group is that even a small and gradual rate rise by the Fed could upset the apple cart. There’s investor complacency concerning bond yields, argues Dubravko Lakos-Bujas, chief U.S. equity strategist at JPMorgan.
 
GLOBAL YIELDS ARE at all-time lows, and stock market expectations “are contingent on yields staying extremely low.” Interest-rate-sensitive stocks—consumer staples, utilities, and telecoms—have been leaders of the 7% market rally this year. The fear is that if yields move higher, these sectors will derate and cause a market pullback, Lakos-Bujas adds.
 
Russ Koesterich, head of asset allocation at the BlackRock Global Allocation fund, concurs. In their relentless search for yield, the “bond market refugees” have turned to defensive sectors, such as staples and utilities, for good dividend yields and the perception of safety. “These stocks have done well, but it is only sustainable if you believe the 10-year Treasury yield will be permanently stuck where it is today,” he says.

“You don’t need much of a rise in rates to see a big move [down] in the stocks. It’s a very tight relationship.”
 
The JPMorgan strategist, who has a 2000 year-end target on the S&P 500, down from 2200 last December, points to the market’s quick drop on Friday, Aug. 26, as an example of what could happen if rate expectations are disappointing. That day, stocks slid 1% in roughly 30 minutes following comments by a Fed official that a rate increase in September was still possible.
 
TIGHTER FED POLICY is one of the reasons David Kostin, Goldman Sachs’ chief U.S. equity strategist, believes that by year end, the market could be in for a “drawdown, not necessarily a correction,” from current levels. Kostin, whose year-end target is 2100, adds that there is probably a higher potential now for a September rate hike than the market expects.
 
                                  
Lately, the word “correction,” or a 10% drop in the market from its highs, has been uttered more times than is typical among our strategists. In addition, election uncertainty and punk earnings growth this year, slowing corporate share buybacks, and high valuations make the Goldman analyst cautious.
 
Says Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America Merrill Lynch: “We do see a sizable probability of a correction” in the coming months. She has a 2000 year-end target.

Besides election uncertainty, she notes that market valuations are expensive versus their historical levels, underlying sales growth is at a three-year low, and Chinese economic expansion might be disappointing.
 
There is a view among some market participants that as monetary stimulus ends, fiscal stimulus will take the rally’s baton, she says. But, she argues, expectations for this are too high.
 
Comments JPMorgan’s Lakos-Bujas: “Increased discussion of coordinated fiscal stimulus among the developed nations would make me more constructive on markets…but so far, that’s just high hopes and nothing concrete.”
 
Both Subramanian and Lakos-Bujas believe bottom-up industry analysts’ EPS consensus forecasts for 2017 will prove too high. Profits are improving, but not at the rate that the Street is predicting, Subramanian says.

THE BULLS BEG TO DIFFER, at least when it comes to 2016’s second half. From a mathematical point of view, earnings almost have to improve, if only because energy-sector profits should stop being a huge drag, notes Prudential’s Praveen. In fact, oil-patch earnings comparisons should turn positive in the fourth quarter.
 
The U.S. equity market is the world’s best, as EPS expectations are “pretty achievable” for the next two quarters, contends Adam Parker, head of U.S. equity strategy at Morgan Stanley. At $122.70, he has the highest EPS estimate in our bunch. Last December, Parker had a base-case S&P 500 index target of 2175 for 2016 and his new target for mid- 2017 is 2200, assuming about 4% EPS growth. 

Compare that with the rest of the world, where profit growth is in decline, he says. His bull-case scenario is for an S&P 500 level of 2475 in 12 months if EPS growth accelerates to 6%, as investors aren’t positioned for such an improvement, according to Parker.
 
Equities offer a better risk-reward proposition than bonds, he argues. An investor gets modest earnings growth, 2% return through share buybacks, an over-2% dividend yield, plus a “call option” on the possibility that earnings can grow, the Morgan Stanley strategist avers. Among the stocks that Parker likes are Biogen (ticker: BIIB) and NextEra Energy  (NEE). (See table below.)
 
Stocks are cheap relative to bonds, Prudential’s Praveen says, citing the earnings yield gap, another traditional valuation method. The earnings yield, the inverse of the P/E ratio, is now 4.9%, based on a trailing 12-month EPS P/E ratio of 20.5 times. That towers over a yield of 1.6% on the 10-year Treasury bond. The 3.3 percentage-point spread has narrowed from 3.76 points in mid-December, but it remains significantly wider than the 1.4-point average of the past 20 years.
 
PRAVEEN, WHOSE YEAR-END target of 2300 is the highest in our survey, says a combination of global central bank liquidity, improved EPS growth, investors’ appetite for yield, good consumer-spending growth (at 3.5%), and a rise in investment spending should push the market higher. The last will start to see the drag from energy investment abate and will benefit from inventory rebuilding, adds Praveen, who expects EPS growth of 1% in the third quarter and 8% in the fourth.
 
That earnings gains will ratchet up in the second half of 2016 isn’t much in dispute. The question is: Has the market already discounted 2016’s improvement, and will 2017 EPS growth disappoint?
 
AMONG SECTORS, our market pundits still bet on technology to be a winner, a perennial view, both for attractive profits in a low-growth world and relatively low valuations.
 
Says Federated’s Auth: “All the talk of a new technology economy back in 1999 was premature. But now it’s coming to pass.” Given the high valuations already in staples and utilities, if the market goes higher, it will in part have to go through technology, adds Auth, who lists Alphabet GOOGL - (GOOGL), the parent of Google, as one of his favorite tech picks as well as telecom Verizon Communications  (VZ) and health-care stock AbbVie (ABBV).
 
Goldman’s Kostin likes sectors that he believes are set to grow irrespective of the economy, such as health care. That’s another preferred group among our strategists, because valuations have dropped in the face of political controversy over drug pricing, and the group’s growth profile remains relatively robust. One of Kostin’s picks is biotech company Amgen (AMGN).
 
HEALTH CARE REMAINS a controversial sector, and problematic for some strategists, who fear that a Clinton presidency or a rising tide of populism could lead to strict drug-price regulations.
 
This sector is down 5% since July 2015, making it the worst performer in that period, and BofA Merrill Lynch’s Subramanian says the group’s valuation is back to where it stood during the Bill Clinton health-care-reform scare, back in the 1990s. “What’s priced in is a pretty dramatic upheaval,” she says, “but what [reform] might get done is probably of lesser magnitude than the market is discounting.”
 
Energy stocks, after their 32% drop since mid-2014, are now almost as favored as tech—unsurprising, given their low stock prices and that oil appears to have stopped its free fall. The sector is an overweight for Jonathan Glionna, head of U.S. equity strategy at Barclays Capital. Easier quarterly earnings comparisons lie ahead, he says. The brokerage expects oil prices to rebound, bolstering energy-sector earnings.
 
THE MOST HATED GROUP is consumer staples, up 8% this year. As mentioned, as bond proxies with high valuations and low growth, these stocks could drop sharply as interest rates rise.
 
Stocks have been a challenge for actively managed funds. A recent JPMorgan report says some two-thirds of U.S. fund managers are underperforming their relevant benchmark this year. It isn’t going to get easier.
 
Our strategists note that their targets could be buffeted by wild cards, such as election surprises or Fed rate moves that are more hawkish than the market expects. Additionally, weakness in China or further post-Brexit turmoil in Europe, both economic and political, could have a negative impact. Separatist moves are growing there. And then there is the frail recovery in the energy sector.
 
Even some bears concede U.S. stocks are a better buy than bonds at this point, but the Street’s strategists aren’t as bullish as they used to be. The contrarian wag in us would like to take that as a signal to take the opposing view. However, as the market enters September, historically its most dangerous month, standing near an exit might be prudent.