Market Perspectives - July 2013

2013 midyear outlook: Time to change your focus?


By John Manley, CFA, Chief Equity Strategist

“The fundamental things apply as time goes by.”
Herman Hupfeld, from As Time Goes By

“Second verse, same as the first!”
Peter Noone, from I’m Henery the Eighth, I Am

For those of us who (try to) predict the equity market, the latter quote is probably too much to hope for. However, I think that, for a number of market participants, continued upward pressure on prices in the next six months, without a substantial pullback, would be a surprising and frustrating experience. The (mis)perception of risk is all around us. In our opinion, there has been one pervasive, dark consensus on Wall Street for the past four years: “One of these days, we will have to pay for the economic and monetary excesses of the past 25 years. Sooner or later, all of the debt, all of the promises of pensions and health care will come due, and we will have to get by with less growth and less wealth.”

This anxiety, whether true or false, has kept a large number of potential equity buyers on the sidelines. It has kept them in risk-free investments that are largely return-free as well. Even now, after a six-month surge in stocks, risk aversion remains just beneath the surface, rising to prominence with every sharp, nasty, and shallow correction that arises. It has been a floor to the downside and fuel for the upside. When actual bad news arrives, it finds its arrival vaguely anticipated. When the news is good or even ambiguous, the market is pleasantly surprised. We suspect that, like many other factors, this attitude will be as influential in the second half of 2013 as it was in the first half.

Even now, after a six-month surge in stocks, risk aversion remains just beneath the surface, rising to prominence with every sharp, nasty, and shallow correction that arises.

We also believe that the more recently perceived (and real) risk (that of earning no return on a riskfree investment) will continue to affect the markets in the second half of the year. The Fed’s attempt to stimulate the economy through low interest rates has made it hard on those who believe that they can avoid risk in safe investments. It is all well and good to say “I worry about the return of my investments more than the return on my investments” until the cost of simple existence begins to eat into the corpus of one’s capital. Then the perception of going broke safely becomes a painful reality, and the futility of trying to avoid risk in the future becomes apparent. We believe that this dawning realization will continue in the second half of the year to push money out of cash into stocks.

The tapering of quantitative easing (QE) may reduce the power of positive monetary pressure; we do not believe it will reverse it anytime soon. We think that earnings should play an increasingly important and increasingly positive role in the equity market in the second half of this year. We know that profitability numbers are high by historical standards. However, comparable periods in the past that represented peak earnings levels coincided with strong and vibrant economic activity. Given Europe’s recession, China’s slowdown, Japan’s devaluation, Latin America’s disarray, high unemployment numbers in the U.S., and the resultant stimulus from the world’s central bankers, we find it difficult to believe that economic activity and, therefore, earnings have peaked.

Earnings growth and its importance in sector performance

The direction of earnings expectations has been strangely positives for almost two years. In that time, numerous pundits have made numerous predictions that S&P earnings were on the verge of collapse. In fact, consensus projections for 2012, 2013, and 2014 have all consistently declined. However, the time-weighted S&P 500 Index consensus earnings expectations over the next 52 weeks has consistently risen, as higher numbers from the out years gradually replace those from the current year. By our calculation, that number currently stands at a bit over $116, and it still appears to be rising. This puts the S&P 500 Index’s forward price-to-earnings multiple (one measure of how expensive a stock is) at a mere 14.2x, even after the stellar price appreciation of the first half. We infer a good deal of skepticism from this modest valuation, especially in the face of minimal returns from sitting in cash and low-yielding high-quality bonds.

We believe that earnings growth, particularly positive surprises in earnings growth, will be an important factor in sector performance in the second half of the year.

If the forward consensus earnings number grows at less than a 5% annualized rate in the next 18 months, the projection for calendar year 2015 could reach $125 by year-end 2014. Placing a historically middling multiple of 16x on that results in our target for the S&P 500 Index to hit 2,000 by year-end 2014, which is a nice gain from its current levels of around 1,600. We would urge investors to focus on that target rather than anything we might say about this year-end. To us, it’s remarkable that we are able to project an aggressive target with modest and meek parameters. In our opinion, this is largely due to investor fear and skepticism.

We believe that earnings growth, particularly positive surprises in earnings growth, will be an important factor in sector performance in the second half of the year. In our opinion, the sector rotation in the first half was an almost textbook example of a bull market following hard on monetary stimulus and then economic growth. A classic bull market begins as the Fed pushes liquidity into the economy to improve growth. On its way to the economy, the liquidity flows through the capital markets and pushes some or all of them higher. With stocks, the first groups to move are traditionally in the early-cycle sectors (such as health care, consumer staples, and utilities), which lack economic sensitivity. When the liquidity reaches the economy, the first positive effect is in the housing market. As the housing market improves, consumers become more confident about their wealth and begin to spend more. Traditionally, the next area to move is the consumer cyclical sector. As corporations respond to greater consumer activity, the next rotation is toward industrials and information technology (IT). Only at the end, when capacity becomes tight, do the late-cycle stocks (commodities and materials) take the lead.

... we find that many of the positives that helped the U.S. equity market in the first half of 2013 are still in place.

It’s only a theory, and it certainly doesn’t work all of the time, but it seems to be playing out that way today. We believe that the second half of the year will see more cyclical names doing better. We are recommending an overweight to both industrials and IT. We believe that earnings and stock prices in these areas will benefit as confidence in the sustainability of a domestic recovery increases and the potential for international growth begins to coalesce. In our opinion, IT should benefit as the corporate upgrade cycle continues and pushes efficiency even higher. The industrials should be helped by an infrastructure buildout to further exploit fracking technology (for tight natural gas deposits) and the resultant relative cheapness of energy in the U.S. Slow-growing labor costs, improving productivity, and low energy costs are key reasons multinational businesses may want to operate in the U.S.

Our only noncyclical overweight is health care, where we believe the rollout of federal health care should benefit the large-capitalization pharmaceutical and device companies, while mid-cap biotech companies are helped by new products and the potential for merger and acquisition activity. The sector is not cheap, but fundamentals can drive another six months of outperformance, in our opinion. We are recommending underweighting the utilities and telecommunication services sectors. In our opinion, the bond-like characteristics that have driven them to high valuations may work against them in the second half.

International equities: Watch the fundamentals

While our focus remains on the U.S., some international markets also interest us. The performance gap between the U.S. and other countries is fairly large and, we suspect, will narrow at some point. We believe that it is too early for fundamentals to justify this on a short-term basis. We would note that Europe, for all of its problems, is suffering from a largely self-induced recession. We suspect that growth in China is starting to stabilize but also that equity participation should be selective, with a particular aversion to the financials sector. Despite what some people may call “favoring the best house in a bad neighborhood,” we actually think the U.S. is an improving house in an improving neighborhood.

In summary, we find that many of the positives that helped the U.S. equity market in the first half of 2013 are still in place. Valuations are reasonable if not modest. Earnings continue to advance, despite expectations to the contrary. The Fed continues to accommodate and, we suspect, will continue to do so long after QE3 has withered and gone. On the other hand, we sense that the wall of worry we climbed in the first half is still in place and that investor anxiety will continue to influence the markets.



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