Market Update – April 15, 2011
Pros and cons
By John Lynch, Chief Equity Strategist
In our most recent edition of Market Roundup, we asserted that despite geopolitical and geological challenges, the financial markets held up quite well during the first quarter. The market’s movements, though, were not linear, as volatility persisted and will likely continue for the foreseeable future. Given the many uncertainties, we’d like to review the pros and cons that are backstopping the current investment environment.
There are many examples supporting the bullish case for investing in equities:
- After more than two years of negative fund flows, investors are returning to the equity markets, as made evident by the steady increases in net positive fund flows thus far in 2011.
- The Federal Reserve’s quantitative easing program to purchase $600 billion of U.S. Treasury securities—dubbed “QE2”—will continue through the end of June, increasing the likelihood that investors will pursue higher-yielding assets, such as equities.
- Nominal U.S. gross domestic product (GDP) and overall U.S. corporate profits are at all-time highs. Yet the Dow Jones Industrial Average and the S&P 500 Index still remain 15% to 20% below their peaks.
- Despite fears of deficit spending domestically and sovereign credit risks in Europe, there appear to be few, if any, signs of stress in the credit markets. For example, three-month LIBOR (London Interbank Offered Rate) is currently yielding less than 0.30%, compared with 0.50% during the periods of stress experienced last summer. LIBOR can spike when banks question the ability of other banks to pay back loans. If the banks still trust one another, they’re more likely to trust the rest of us.
- Equity market leadership is still cyclical, with the energy, industrials, and consumer discretionary sectors outperforming the market year to date. Typically, if a market is becoming overvalued, defensive groups such as consumer staples or utilities tend to lead performance.
- Corporate activity is accelerating, characterized by mergers, business investments, or increases in employment. Companies now have a degree of clarity relative to health care, financial, and fiscal policies, enabling them to more effectively use their large cash hordes to help drive economic and profit growth.
- Equity market technicals remain favorable. While the S&P 500 Index recently dipped just below its
50-day moving average, the trend over the past 50 days (and 200 days) remains positive, suggesting that investors will continue to “buy the dips” as stocks approach recent support levels.
- Stocks are also favorably priced relative to interest rates, inflation, and their long-term averages. For example, over the past 50 years, the 10-year Treasury bond has averaged around 7.0%, while headline inflation has grown annually in the 4.0% range. Given that the benchmark Treasury yield is trading at approximately one-half of its long-term average and inflation is also growing at about one-half of its usual annual pace, it stands to reason that the price-to-earnings (P/E) ratio on stocks may also rise in the coming months.
- With the market currently trading at around 13.5 times the consensus operating earnings estimate for the S&P 500 Index—which has risen to above $97.00 for 2011—it is conceivable that the P/E ratio could rise to at least 15 times earnings (below its long-term average of 16.5). This could still propel the index to around 1,450 sometime in 2011.
- The longer-term story also looks favorable for stocks, since the 10-year annualized equity returns are just beginning to rebound from secular lows. Previously, this has been an encouraging indicator for longer-term returns. See Chart 1.
Chart 1: S&P 500 Index 10-year annualized returns: 1920–2010
Of course, it wouldn’t be a market if there weren’t any sellers. Consequently, the bearish case may also seem just as convincing:
- It is possible that the market may decline as the Fed stops “supporting it” at the end of June. Indeed, we suspect that a pullback is likely as market interest rates creep higher once the Fed ends quantitative easing (QE2).
- China continues to take steps to rein in inflation pressures through increased reserve requirements and higher interest rates. Policy that is deemed too aggressive could damage investor sentiment, since China is viewed as the primary engine for global growth.
- European credit risks remain high as Portugal postures for a bailout. In addition, interest rates on Greece’s debt continue to soar, suggesting that the market is already demanding a restructuring of last year’s bailout package. Moreover, it is possible that these crises may pale in comparison to the potential credit problems emanating from Spain.
- An escalation of federal deficit spending concerns and/or a prolonged, confidence-reducing debate on proposed budgets and debt ceiling limits could propel market interest rates significantly higher, while driving investor sentiment much lower than what is widely expected.
- Economic growth in the U.S. may also fail to meet consensus expectations, as credit, housing, and employment have not contributed in this expansion to the extent that they have in past cycles.
- The prospects for corporate earnings may also disappoint investors, as assumptions relating to revenue growth and margin expansion diminish with lower demand and rising input costs.
- Growth in consumption may be limited by several factors, but especially by high oil prices. Although oil prices have come down, they could easily pop with an escalation of the wars in Iraq, Afghanistan, or Libya; geopolitical threats from terrorists; or heightened concerns resulting from political unrest in North Africa and the Middle East.
We continue to believe that equities can climb as the Federal Reserve fulfills its plans to purchase $600 billion in U.S. Treasuries through the end of June. The market is also likely to believe consensus forecasts for GDP and corporate earnings during the first half of the year, pushing stock prices higher as the fundamentals can help “justify” the already impressive technicals supporting the market. Yet we still suspect that the expectations for economic and profit growth are too high and will likely moderate in the second half of the year. Weaker-than-expected contributions from housing, employment, and credit may lessen demand growth, while rising food and energy prices should subtract from margins.
Consequently, we suspect that the S&P 500 Index may trade above 1,400 in the months ahead, supported by a combination of technical and fundamental strength. Yet weaker-than-expected growth in GDP and corporate profits, along with any further problems in Japan or Europe, could put these market gains at risk. If geopolitical or credit risks escalate, we will look for the index to test support in the 1,200–1,230 range, representing a decline of as much as 15%. However, as market interest rates adjust and consensus forecasts for GDP and profits decline to levels closer to our projections, we will look for the S&P 500 Index to begin a gradual recovery as investors ultimately pay a P/E ratio of approximately 15 times our $90.00 estimate. This would result in a market that we would consider fairly valued in the 1,350 range by year-end.
As always, we continue to recommend a fully diversified strategy for long-term investors. Considering relative valuations, we favor stocks over bonds and a slight overweight to large caps over small caps. Growth and value can be equally weighted, while positions in emerging over developed nations can be added on pullbacks.