Wall Street’s top strategists are bullish on U.S. stocks through the end of this year and into 2016. Why they like technology, financials.
The bull has stumbled, but his run isn’t over. Despite the stock market’s first 10%-plus correction in four years, touched off last month by fresh indications of slowing growth in China’s once robust economy, Wall Street’s top strategists remain optimistic that U.S. shares will finish the year with a gain, albeit a smaller one than they previously had forecast. Stocks will pick up the pace in 2016 as investors stronger profit growth, they say.
Collectively, the strategists expect the Standard & Poor’s 500 index to rise to 2150 by the end of the year, which would mean a gain of more than 10% from Friday’s close of 1921.22. Their year-end outlook implies a return of 4.4% for the full year. Barron’ssurveys a group of 10 prominent market strategists every September and December, to gauge their outlook for stocks, bonds, and the economy in the year ahead.
With memories of the 2008 financial crisis still somewhat fresh, it might seem churlish to sniff at a 12-month return of 4% to 5%. Yet 2015 has hardly measured up to Wall Street’s initial expectations. Last December, the strategists were forecasting that the S&P would advance 10% in 2015, to 2200; the index peaked year to date in May, at 2130.82. By way of comparison, stocks gained 11% last year, 30% in 2013, and 13% in 2014.
The strategists’ year-end targets for the S&P 500 range from a low of 2100 to a high of 2200. That’s a much tighter range than in December.
The average of their 2015 profit expectations for the S&P 500 is $120.25, down from $127 as the year opened. These market seers see S&P earnings rising by 7% in 2016, to $129. (That consensus figure is based on eight estimates, as some strategists haven’t yet established their 2016 price targets or earnings estimates.)
With the summer’s setback, the market’s valuation has fallen from historically high levels. The S&P 500 index now trades for 14.8 times 2016 consensus earnings estimates, down from 16 to 17 times forward estimates earlier in the year, and a long-term average of 15. Some of our seers look for the stock market’s price/earnings ratio, or P/E, to expand in the months ahead, possibly returning to 16 or 17 times earnings.
At this point in the year, there isn’t much of a gap in earnings estimates between the Street’s strategists and industry analysts, who are predicting S&P profits of $119. The analysts, typically more optimistic, forecast an 11% gain in 2016, to $132, according to Thomson Reuters.
ALTHOUGH THE TONE of the strategists’ commentary seems less upbeat than in past surveys, there is no dissent in the group on the market’s direction: upward. Any disagreements are over how fast and by how much. “U.S. stock valuations are reasonable given the prospects for growth and inflation,” says Russ Koesterich, global chief investment strategist at BlackRock, who worried about “stretched” valuations last December.
Near term, he says, stocks are “particularly attractive relative to bonds.”
Dubravko Lakos-Bujas, chief U.S. equity strategist at JPMorgan Chase, agrees. Compared with international markets, the U.S. provides stocks of superior quality, he says.
The yield on 10-year U.S. Treasury bonds fell last week to 2.13% from the previous week’s 2.19%. Yields were 2.12% at the start of this year. The strategists’ mean forecast calls for yields to rise to 2.47% in the fourth quarter (bond yields rise inversely to prices), based in part on an assumption that the Federal Reserve will move to lift interest rates before the end of the year.
The S&P 500’s dividend yield is 2.24%.
The “earnings yield gap” is another measure that indicates stocks are fairly cheap. It compares the market’s earnings yield, or the inverse of the P/E, now about 6%, to the 10-year Treasury yield. The spread is roughly four percentage points, much higher than the 1.2-percentage-point average of the past 20 years.
Poor economic data from China rocked markets again last week. Still, the U.S. market’s correction “was a long time in coming,” says Jeffrey Knight, head of global asset allocation at Columbia Threadneedle Investments. The downdraft here had more to do “with the length of time since the last [major selloff], and investor complacency, than with any particular catalyst, China notwithstanding,” he says.
Knight expects the S&P 500 to end the year at 2150.
The magnitude and speed of the initial selloff in August were surprising and relatively rare in the annals of stock market history, says Adam Parker, Morgan Stanley’s head of U.S. equity strategy. It might be that “China is a scapegoat” for other issues, he says, such as the dollar’s rise in value, emerging-market woes, plunging oil prices, and the uncertainty over the timing of the Fed’s next move.
Despite these concerns, Parker sees “a relatively benign backdrop for U.S. equities,” with slow economic growth, low inflation, and a gradual but slow tightening of monetary policy by the Fed.
JOHN PRAVEEN, chief investment strategist at Prudential International Investments Advisers, recently lowered his 2015 S&P target by 100 points, to 2150. Nevertheless, like most strategists, he thinks earnings could improve in the current and fourth quarters, on the back of stronger U.S. gross-domestic-product growth. U.S. GDP was revised upward to 3.7% in the second quarter, but the economy grew by a mere 0.6% in the first three months of the year.
Praveen expects GDP growth to top 3.5% in the second half, helped by a buoyant housing market, solid consumer spending, and rising consumer confidence and employment. The strategists’ mean prediction calls for 2.5% GDP growth in 2015, up from 2.4% in 2014.
For all of the concerns about China and emerging-market dislocations, David Kostin, chief U.S. equity strategist at Goldman Sachs, says the Middle Kingdom’s struggles “will not derail the U.S. economic expansion.” Approximately 2% of the revenue of S&P 500 constituents is generated in China, and U.S. exports account for just 13% of GDP, with less than 1% going to China.
As even neophyte investors know, stocks are driven by profit growth—or the lack thereof. With the economy expanding, our strategists expect second-half corporate profits to exceed first-half results and, more important, exceed expectations.
Even before this year’s setbacks in China and other emerging markets, U.S. stock indexes were struggling to make big strides. Blame that on subpar profit growth in general, and trouble in the energy sector in particular.
IN THE FIRST AND SECOND QUARTERS, S&P 500 earnings rose just 2% and 1%, respectively. That is far less than the double-digit profit gains projected last October, according to Thomson Reuters. Additionally, this year’s profits are down sharply so far from 2014, when S&P earnings rose 8%. S&P 500 energy-sector profits plummeted nearly 60% in this year’s first and second quarters. Analysts look for a 3.4% decline in S&P 500 earnings in the third quarter, and a 2.2% rise in the fourth. That would not seem to be a promising recipe for a meaningful stock market advance.
But BlackRock’s Koesterich expects that third- and fourth-quarter earnings will be better than expected. After the anniversaries of the dollar’s rise and oil’s plunge—which both began about 12 months ago— the comparisons will get easier, he says.
U.S. economic data might be spotty, but they reveal that the U.S. economy is weathering the slowdown in China. The Institute for Supply Management reported last week that its manufacturing purchasing managers index fell to 51.1% in August from 52.7% in July, but the latest level still indicates expansion. Orders for durable goods rose 2% in July, after a 4.1% increase in June.
Prudential’s Praveen expects S&P 500 earnings to jump nearly 5% for the full year, after a poor first-half showing.
Earnings will look better for many non-energy-sector companies, even if business doesn’t improve, says Tobias Levkovich, chief U.S. equity strategist at Citigroup’s Citi Investment Research. Some of the drag from lower oil prices will dissipate, along with the some of the impact of a strong dollar on companies with international sales. Sentiment is subdued, valuations are OK, and there will be benefits from job growth, wage increases, and lower energy prices, says Levkovich. He has a year-end target of 2200 on the S&P 500 index.
According to Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America Merrill Lynch, investors will be begin to anticipate better profit growth for 2016 toward the end of this year, which will help to bolster stocks prices. She has a year-end target of 2200 on the S&P 500, one of three strategists with the same telescope.
Corporate share buybacks, which reduce shares outstanding, will continue to contribute to earnings-per-share growth, as has been the case in recent years, says JPMorgan’s Lakos-Bujas. He thinks there will be positive revisions to earnings per share, and notes that buybacks among S&P 500 companies already have totaled about $439 billion so far this year. They are on pace to surpass the previous annual record of $690 billion, according to JPMorgan. “Buybacks could add two to 2.5 percentage points” to earnings growth if the pace persists, he says.
JONATHAN GLIONNA, head of U.S. equity strategy at Barclays, is best described as a subdued bull. Glionna, who hasn’t changed his 2015 year-end target for the S&P 500 since last December—it’s 2100—concedes that because the market has reset lower, there is a “decent outlook” for the rest of the year. But with the index trading for 1.6 times expected sales, he worries that investors might be paying too much for growth. Historically, parity has been the rule.
The price/sales ratio is an even loftier 3.5 times for the 100 stocks in the S&P 500 with the fastest-growing expected revenue. Glionna says that both revenue and earnings growth aren’t strong enough to justify so high a valuation.
UNTIL CHINA ROCKED WALL STREET by devaluing its currency in the aftermath of disappointing revelations about the pace of the nation’s growth, the Federal Reserve’s intended actions were the talk of the Street. It has been expected, at various times and in various quarters, that the U.S. central bank would raise its interest-rate target in September, or December, or maybe even next year.
The strategists Barron’s consulted generally agree that the Fed will raise rates sometime this year—and that it will be a good thing, too. But they don’t agree on the timing. Most are counting on calm returning to Asian markets, and they expect the Shanghai Composite stock index, which has fallen 40% from its highs, to stabilize at some point, too.
Similarly, they look for oil prices to bottom and the U.S. dollar to stop surging. Greater stability in other markets and asset prices could encourage Fed Chair Janet Yellen and her team to act, rather than delay a decision on rates.
At the start of the year, the strategists expected the Fed to begin normalizing monetary policy by midyear, by lifting its federal-funds rate target above the abnormally low 0% to 0.25% range that has prevailed since December 2008. The federal-funds rate is the overnight lending rate banks charge one another for funds maintained at the Fed.
Such predictions have since gone by the boards. The strategists are evenly split at this juncture between those who see a modest hike coming later this month or in December. The call typically is made by each firm, not by individuals on the strategy team.
For years, investors took solace from the Fed’s highly accommodative monetary policy. But now it is time for rates to rise and credit to tighten, the strategists say, as the U.S. economy looks to be gaining steam.
FED WATCHERS HAVE been viewing a monetary-policy-themed version ofGroundhog Day for the past two years, wherein each time it seemed that the Fed was about to raise interest rates, something happened to stay its hand. Last year, European bond yields plunged. Lately, there have been fears that dislocations in China and other emerging markets could restrain inflation or promote deflation. The U.S. central bank maintains an inflation-rate target of 2%.
“If the volatility continues, the Fed won’t hike in September,” says Stephen Auth, chief investment officer of Federated Investors. It will do so when things calm down, says Auth, who has been among the most bullish Street strategists for several years.
He recently took his 2015 S&P target down to 2200 from a prior 2350. But next year, he expects the benchmark index to rally to 2500.
“I’m looking forward to a [rate] hike,” says Auth. “The market needs a return of normalcy.”
A 1% federal-funds rate is good for the economy, good for the banks, and still good for corporate debt funding, he says.
Auth sounds no less bullish than in December, despite the ratcheting down of his S&P price target. He sees an “impressive rally” in the fourth quarter. Markets are underestimating the ability of China to get its house in order, and with a “massive $3.5 trillion in currency reserves,” the country has the wherewithal to combat its problems, he says. This isn’t like the emerging-markets problems of 1997-98, when underdeveloped countries had few currency reserves and current account deficits, he says. China, in contrast, is a creditor nation.
By November or December, says Auth, investors will see that “China is not blowing up” and earnings are improving. With the U.S. job market showing strength, consumers reaping the benefits of lower energy prices, and the dollar’s muscle baked into earnings comparisons, the “stage is set” for another big stock market rally in the fourth quarter, going into 2016. “That’s where you will get a big rush into equities,” says Auth.
Bull markets, he notes, end when recessions hit or valuations become extended, and “we aren’t there yet.”
FOR THE PAST SEVERAL YEARS, investors whooped it up each time the Fed was forced to postpone raising interest rates. Now, however, “if the Fed doesn’t tighten, it would be a negative signal on a global basis,” says Merrill’s Subramanian.
“It needs to be this year,” adds BlackRock’s Koesterich of a rate increase. “When you look at the strength in the labor market, it is hard to justify that zero is the correct policy rate,” he says.
The U.S. Dept. of Labor reported on Friday that unemployment fell to 5.1% in August from 5.3% in July.
It is one thing to be bullish about the outlook for the S&P 500 and its fellow indexes. But where, exactly, should investors put their money? A majority of strategists favor information-technology stocks, particularly after the sector’s 5% slide this year. Tech, says Barclays’ Glionna, offers strong profit margins, the fastest dividend growth in the past three years, for which it doesn’t get credit, and share buybacks, which help to lift earnings per share, and thus, stock prices.
Moreover, capital-expenditure trends are favorable, notes Citi’s Levkovich. Corporations need to refresh their computer systems and move into cloud computing, jobs growth leads to use of more technology, and cybersecurity is becoming increasingly mission-critical.
Certain technology subindustries, such as semiconductor manufacturing, could benefit from the recent decline in the Chinese yuan, which will reduce costs, says JPMorgan’s Lakos-Bujas.
Indeed, in a world where growth is weak, tech is one of a few areas likely to see revenue gains. And now, valuations have fallen. Kostin, of Goldman Sachs, likesAlliance Data Systems (ticker: ADS), a Plano, Texas–based provider of branded credit-card, marketing, and customer-loyalty programs.
FINANCIALS HAVE REPLACED industrials as the Street’s second-favorite market sector. When the Fed finally lifts its rate target, perhaps to 1%, that will benefit banks and insurance companies. Net-interest-margin spreads could widen. Strengthening economic growth could foster credit growth, while an expanding housing market could be a positive for this mostly domestic sector, which is down 9% this year. And like tech, Glionna points out, financials are showing fast dividend growth in 2015.
Morgan Stanley’s Parker says financials could see the most growth in shareholder return, and they have little exposure to the rising greenback. Valuations are unchallenging, as well. Among them, he likes Bank of America (BAC).
There are differences of opinion, too, about the details of a market recovery. For example, Goldman’s Kostin advocates a “Buy America” theme, favoring companies that derive most of their profits from the U.S. and have little or no exposure to emerging markets.
Others, like Subramanian, say it is time to buy the now-cheaper megacap U.S. stocks that have substantial international exposure because they are able to grab share during tough times.
She is also one of the few strategists to favor the decimated energy sector, which looks to be an interesting contrarian call. Energy stocks are down 21% or more this year, reflecting a precipitous drop in the price of oil that began last fall. Subramanian notes that mutual funds specializing in large-cap stocks have record underweight positions in energy shares, even as industry analysts have stopped cutting their earnings estimates and are starting to revise them upward.
The sector trades for 1.5 times book value. The last time the group reached such an inexpensive extreme, it outperformed in the following year by 33 percentage points.
Subramanian likes ExxonMobil (XOM), which makes her a rarity these days. The stock yields nearly 4% and typically suffers less than other integrated energy companies when oil prices fall, due to the benefit of lower prices to its extensive refining operations.
KNIGHT’S FAVORABLE VIEW of telecom stocks is another out-of-consensus call. The group is down 6% this year. In the past, strategists have viewed telecoms as bond proxies that would be hurt by rising rates. The Columbia Threadneedle strategist says the sector, dominated by Verizon Communications (VZ) and AT&T (T), offers attractive dividends and defensive characteristics, and has underperformed in the recent selloff. That creates an opportunistic entry point, he adds.
Knight also thinks investors who want to “buy the dip” should look at markets outside of the U.S., “where there are way bigger dips to buy.” Some markets fell for good reason, he adds, but he notes that Taiwan and Korea might offer good value.
Another internationally focused strategist is Koesterich. Stocks outside of the U.S. are more reasonably valued, and face less of a currency head wind, he says, particularly in developed markets such as Europe and Japan. European net profit margins, running around 6%, have room to grow, compared with record-high U.S. profit margins of 8% to 9%.
German stocks are down 6% in dollar terms this year. Koesterich likes the iShares Currency Hedged MSCI Germany exchange-traded fund (HEWG), a currency-hedged ETF that mimics the MSCI’s index for Germany. (IShares is owned by BlackRock.)
The utilities sector, down 14%, is the least favored among the strategists. It is likely to be affected negatively when the Fed finally begins to raise rates. It also offers little growth, and the shares aren’t particularly cheap.
The strategists don’t think much of materials stocks either, as plunging commodities prices in the past 12 months have dented companies’ revenue, earnings, and prospects.
ALTHOUGH WALL STREET’S STRATEGISTS generally have been bullish and prescient in recent years, many things could dash their optimism. Perhaps most important, they are betting that the dislocations in China and emerging markets will be temporary in nature, and won’t have much of an impact on the U.S.
China’s economic growth might continue to slow, “but it will be good enough not to blow the rest of us up,” says Federated’s Auth.
Yet, investors’ fears about contagion could overwhelm reality. As JPMorgan’s Lakos-Bujas points out, in extended selloffs such as last month’s, technical factors like poor breadth, and reduced liquidity sometimes overpower fundamentals. “Spikes in volatility can create technical deteriorations that foster a negative feedback loop, and fundamentals no longer hold,” he says.
In bull years, the rally that began in March 2009 is getting old. But no matter the tremors in the rest of the world, earnings will drive stock prices over time. The big bet on Wall Street is that corporate earnings will improve next year, allowing this bull market to celebrate yet another birthday.
