Market Perspectives - July 2012
2012 mid-year outlook: Looking past the cliff
EquitiesBy John Manley, CFA, Chief Equity Strategist
Investors' bleak expectations and their intolerance of any action or inaction that would encourage deflationary conditions were obvious in the equity markets' performance in the first half of 2012. Stocks gave us quite a ride: strong and persistent gains in the first quarter, stalling momentum and rotation in April, sharp declines in May, and improbable rebounds in June. There was something for everyone, and all prognosticators had their moments of triumph.
While the fundamentals of individual companies still mattered, sector performance was driven largely by political events and macroeconomic factors. Signs of economic stability or political and fiscal responsibility brought outperformance to cyclical sectors and groups. Increased doubts and fears led these same cyclicals lower during the first half of 2012. Top-down perceptions drove sector performance, and many of those perceptions were political and international in nature. It was a hard environment in which to consistently outperform using a single, unchanging strategy.
To comprehend what has happened and to thoughtfully anticipate what could happen, it is important to understand the beliefs and expectations that are currently held by investors.
In our opinion, there has been one great consensus on Wall Street since the end of the bear market of 2007 to 2009: "At some point in time, we are going to have to pay for the excesses of the past 25 years. Someday, we will have to recognize that all of the debt cannot be repaid and that all of the promises cannot be fulfilled. We will all have to get by with less: less wealth, less growth, less opportunity." Almost all investors either believe or deeply fear that this is the case. The point of debate (and, in the past three years, the source of gains and losses in the equity market) has been when?
At times, (such as March 2009, September 2011, and, most recently, the last week of May 2012), the answer appears to be now! Some crisis seems ready to rip the financial and economic fabric of the world and immediately give us our long-awaited doomsday. And then, some central bank or international agency intervenes (on the notion that almost any expense is preferable to the end of the world as we know it), and the problem is pushed into the future. The further into the future the problem goes, the higher the stock market goes. No news is good news until some bad news arrives. And the process begins again.
A range-bound equity marketWe believe the equity market is in a trading range and will remain in one for the next six to nine months. Simply put, it is too soon for the market to rise substantially because so many systemic problems have not been resolved or even seriously addressed. On the other hand, it is probably too soon for stocks to decline significantly. Valuations are low, expectations are between dismal and skeptical, and there are still tools that can delay (for a while at least) almost any short-term disaster. The marketplace expects bad black swans to arrive on a regular basis. As shown by Chart 3 on the next page, our collective memories of the past 14 years are full of "impossible" events that came to pass.
This nagging anticipation keeps many investors on the sidelines, even though risk-free returns have been lowered to almost nothing. The normally powerful bullish effect of strongly positive monetary pressure is diffused by a fog of fear. However, the pressure is still there and becomes more effective whenever a period of no bad news allows for a partial dissipation of the fear.
Our projection is that the S&P 500 Index will trade in a range of 1,250 to 1,450 over the next several quarters. The boundaries of that range are not quantitatively derived. In our opinion, given current risk-free returns, stocks appear cheap at either end (less than 12 times 2012 consensus earnings expectations at the bottom and less than 14 times at the top). But they are cheap for a number of reasons, and those reasons will take a while to erode.Chart 3: Consensus S&P 500 Index earnings per share for indicated calendar year
The good news is that the markets themselves are beginning to exert pressure on policymakers to make the tough decisions to solve many of our problems. Late last summer and earlier this spring, the U.S. stock market experienced sharp and nasty corrections in response to adverse events both here and abroad. Equity investors were showing signs of decreasing patience with actions or events that would increase deflationary pressures in the world. More and more, the markets seem to be unwilling to let pressing issues be "kicked down the road."
This had not happened for 30 years. In the early 1980s, economist Ed Yardeni's "bond market vigilantes" appeared on the scene and, in the end, rode inflation out of town on a rail. Bond investors had wearied of half-hearted attempts to stifle inflation and took matters into their own hands. Anything that reeked of potential inflation was greeted with a swift decline in bond prices, sending out a clear message: "Doing nothing is not an alternative. The pain that appeared to be as avoidable as the decision was thrust upon us." The markets forced the issue; the issue was addressed and, ultimately, solved.
A look aheadThat is the message for the rest of 2012 and the hope for 2013 and 2014. We believe the equity market is bouncing along the bottom. On balance, stocks should tend to rise in the absence of bad news. When bad news or bad behavior occurs, we believe that market reaction will be sharp and pointed but also short and shallow. Each downturn will push decision-makers toward hard but helpful decisions. Each setback will move fundamentals in the right direction.
We also believe that the sustainability of earnings will be a story that moves us higher over the long run. The current price-to-earnings (P/E) multiple of the market (only slightly above 12 times forward consensus earnings), when compared with an intermediate-term U.S. Treasury yield of around 100 basis points (100 bps equals 1.00%), reflects not only concern about world economies, but also tremendous skepticism about the growth potential of corporate profits. It is well known that by almost any measure (compared with GDP, sales, equity, and investment), profits are at or near 90-year highs. It is equally well known that, once achieved, these levels were not sustained and returned to "normal" within a few years, usually bringing stock prices in their wake. The conclusion seems inevitable: Unless history is denied, the market deserves a lower multiple on such distended results.
This argument is both logical and strong. However, in our opinion, it ignores one important point. Prior periods of high profitability occurred during periods of strong economic activity or growth. Never have profits been this strong when the world's economy is so weak. We believe that efficiency, not cyclicality, has driven and will sustain corporate profits. It is different this time, and that difference argues that the effects of a stronger economy (whenever that happens) still lie before us. If profits do not falter over the course of 2012, we believe that the very real possibility of multiple expansion (if only back to more "normal" levels) exists for 2013 and 2014. So far, reported profits have continued to pleasantly surprise. While encouraging, we realize that only time can prove our thesis. It is a story for the long run, not the short term.
We continue to find growth more attractive than value and large capitalization superior to small. We believe that large, high-quality, cash-rich companies with decent yield (Treasury-plus) and strong cash flows are still reasonably priced. Moreover, we foresee a rising demand for this rather limited universe as more Baby Boomers try to fund their long-term retirement needs. Very few investment vehicles can meet the demands that an extended retirement can bring. Our sector calls remain unchanged. Our first choice remains health care, where large-capitalization pharmaceutical and device companies have endured patent cliffs and rising regulation for half a decade. We are impressed with the ability of companies in this sector to shift spending to emphasize cash-flow (and hence, dividend) growth instead of unit expansion. We like large-capitalization information technology (IT) companies that sell to other companies to make them more efficient and profitable. We believe that emerging markets are attractive in the long run but, over the next six to nine months, would prefer to gain exposure through large, multinational consumer staples companies that cater to an emerging middle class in the emerging world. Finally, energy, our most frustrating call of the first half, remains attractive to us.
We are attracted to the large-capitalization integrated companies as a play on yield and high stable oil prices. Our wildcard is the infrastructure play that may exist because of cheap natural gas. "Fracking" technology (fracturing rocks to extract natural gas) is young and still controversial. However, its potential for extremely cheap natural gas means that money can be spent to make it safer and more attainable by all. We want to own those companies that can safely and cleanly produce natural gas and then efficiently deliver it to the consumer.
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