Outlook 2015: Stick With the Bull
Born in March 2009, today’s bull market is the fourth longest in history—and it isn’t about to end, despite last week’s shellacking. That’s the word from Wall Street’s top strategists, who expect the Standard & Poor’s 500 stock index to rise 10% in 2015. A gain of that magnitude surely would merit applause, coming atop an 8% rally year to date, not to mention 2013’s 30% advance. Almost six years in, the old bull still seems sprightly. Although some strategists are more bullish than others, and some are less bullish than they once were, there is no dissent on the market’s future direction. That owes, in part, to a dearth of attractive alternatives. “It is less easy to make the call than a few years ago, but [U.S.] equities are the best place to be,” says Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America Merrill Lynch.
The strategists’ 2015 targets for the S&P 500 range from a low of 2100 to a high of 2350, with a mean of 2208, compared with Friday’s close of 2002. Subramanian’s 2015 target is 2200.
THIS YEAR’S BULLISH consensus might give contrarians pause, as did last December’s unanimously upbeat forecasts. But it would be hard to argue now with the strategists’ 2013 prediction of a 10% rally in 2014. With just 12 trading days left in the year, the Street’s seers are not far off the mark.
While the bull market has increased the wealth of equity investors, many institutions have had trouble keeping up. A recent Goldman Sachs report notes that 85% of large-cap core mutual funds are trailing the S&P 500 in 2014.
Worse, this lagging performance could continue in 2015. Goldman notes that a growing U.S. economy historically has been associated with a “low dispersion” of stock returns, a fancy way of saying that returns tend to cluster in a tight range. Thus, divergent investment strategies, such as growth and value, become less useful in picking winning stocks. Mutual funds typically trail the S&P in low-dispersion periods, which Goldman expects to persist, as it becomes harder to identify stocks that will rise significantly more than the benchmark.
BARRON’S SURVEYS a group of prominent market strategists every September and December, to gauge the outlook for stocks, bonds, and the economy in the final months of the current year and in the year ahead. Looking to 2015, the strategists see S&P 500 earnings per share rising a mean 7.5%, to $127, from an expected $118 this year. Most believe that higher earnings will be the market’s chief propellant in the new year.
Industry analysts tend toward more upbeat forecasts than the big-picture thinkers, although the current read on 2015 suggests there isn’t much of a gap. The analysts have penciled in earnings estimates of $128.80, according to Yardeni Research.
U.S. stocks are neither cheap nor expensive, based on the market’s current price/earnings ratio of 15.8 times future four-quarter earnings. Few strategists expect the multiple to expand much in the coming year.
“In isolation, U.S. stocks are on the expensive side,” says Jeffrey Knight, head of global asset allocation at Columbia Management. But measured against other financial assets—whether emerging-market equities or developed-market bonds—U.S. shares look strong, he adds. Knight also has a 2015 index target of 2200.
ALTHOUGH STOCKS have tripled since the lows of 2009, the ride has sometimes been bumpy. Consider the 7.4% rout in the early fall—almost enough to qualify as a bona fide correction—or last week’s 3.5% selloff. The first downturn owed to worries about slowing global growth, while last week’s decline reflected anxiety about the sudden, sharp drop in oil prices and energy shares
Many analysts and investors are concerned about how the market will react when the Federal Reserve starts raising interest rates again—a change widely expected around the middle of 2015. A sharp rise in the dollar could mitigate somewhat the effect of higher rates by keeping inflation quiescent. This year’s plunge of more than 40% in oil prices also could help to offset the impact of higher borrowing costs, as it effectively gives a tax break to consumers. West Texas Intermediate crude settled at $57.81 a barrel on Friday—a development almost no one predicted at the start of the year. Every $10-a-barrel drop in the average annual price of oil equates to a potential pickup of about 0.5% in U.S. gross domestic product, according to Citi Research.
IF THE FED maintains its policy of broadly telegraphing interest-rate moves, and if the federal-funds rate (the overnight lending rate that banks charge one another for funds maintained at the Fed) is lifted in a measured and orderly manner from today’s 0%-0.25%, the bull market can progress smoothly, our prognosticators believe. Also, rising rates presumably would correspond with a stronger economy.
U.S. economic output is expected to rise 2.2% this year. The strategists are forecasting continued gains in 2015, resulting in a consensus estimate of 3% growth in GDP. A robust economy will be the engine of corporate profit growth, and could encourage companies to loosen the purse strings when it comes to capital spending and job growth, they say. Share-buyback activity also is expected to remain brisk in the new year.
Again, the U.S. compares favorably with the competition. The Japanese economy has entered another recession, despite policy makers’ push to ease credit. The European economy continues to struggle, as well, and China appears to be slowing from its fevered growth pace of several years ago. In contrast, “the U.S. economy is doing well and has started to accelerate,” says Stephen Auth, chief investment officer of Federated Investors.
Auth has the highest market target among our group; he expects the S&P 500 to end next year at 2350, up 17% from recent levels. Auth and John Praveen of Prudential International Investments Advisors have been the most consistently bullish of our prognosticators in the past three years. Praveen’s 2015 target is 2250.
U.S. GDP ROSE AT A 4.6% annual clip in the second quarter and 3.9% in the third, compensating for a weak first quarter. After five or six years of little to no investment growth, says Auth, “that momentum will carry the economy forward because of pent-up demand from both consumers and the corporate world.”
He expects operating-profit margins to widen and P/E multiples to expand as investors take stock of the positive news. “Growth is good, interest rates are low, and the perception of risk will diminish,” says Auth, one of just a few strategists in our survey to bet on P/E expansion. “Historically, bull markets have had a P/E of 17 to 18 times earnings, with U.S. Treasuries yielding 4% to 5%. An 18 P/E is conservative, since we don’t expect Treasury yields to rise to 4%.”
Ten-year yields fell to 2.08% from 2.31% last week.
Not everyone shares Auth’s optimism on earnings, however. Jonathan Glionna, head of U.S. equity strategy at Barclays, argues that “the quality of earnings isn’t good enough to justify an elevated P/E.”
Gains in earnings per share, he notes, are being driven by record amounts of share buybacks and record-high operating-profit margins. “But there is a missing ingredient: revenue growth,” he observes.
Glionna’s S&P 500 target for 2015—2100—is tied for lowest in our group, and implies a rise of only 5% in the index next year. With S&P 500 companies generating roughly 30% of their sales overseas, and much of the rest of the world experiencing economic malaise or worse, the Barclays strategist says “top-line growth will struggle.”
He expects S&P 500 revenue to rise 2% next year.
How much longer will investors be willing to pay for substandard revenue gains? The S&P 500 currently sells for 1.7 times expected sales, but “it very rarely stays above 1.5 times sales,” he says.
In addition to higher interest rates, Russ Koesterich, global chief investment strategist at BlackRock, also thinks equity multiples are “stretched.” He is looking for a rotation out of U.S. shares and into depressed Japanese and European stocks. “You are likely to see an acceleration in [U.S.] wages, and that means corporate operating margins will come under pressure,” he says.
Koesterich expects the S&P 500 to end next year at 2160.
GIVEN INCIPIENT wage pressures, some strategists take a dim view of consumer-discretionary companies, including restaurant operators, retailers, and lodging concerns—all labor intensive. “We will start to see wage gains in a few quarters,” predicts Tobias Levkovich, chief U.S. equity strategist at Citibank’s Citi Research.
Levkovich recommends avoiding the consumer-discretionary sector, and says its high valuations aren’t sustainable. He also questions whether lower profits in the energy sector will be offset by higher earnings elsewhere. “If somebody doesn’t get hired on a rig in North Dakota, that might mean one less house sold,” he says.
Subramanian notes that consumer-discretionary is the most overweighted sector by active money managers, and that the stocks in that group are fairly expensive, on a variety of metrics. Consumer staples, she argues, could get a big boost from this year’s slide in oil prices, while companies that depend on discretionary spending might realize fewer benefits than expected.
Some of the biggest beneficiaries of lower oil prices could be low-end retailers, which specialize in staples. Wal-Mart Stores (ticker: WMT) could be among the winners.
Energy stocks have been the year’s worst performers; the sector has fallen 26% from its late-June high, and accounted for just 8.4% of the S&P 500’s market capitalization as of the end of November. Energy also is expected to provide 11% of this year’s S&P 500 profit, and if prices remain around recent levels, S&P earnings could be clipped by $1 to $2, Subramanian says. She recently reduced her 2015 profit forecast to $124, from $126, due to the turmoil in the oil patch.
Adam Parker, head of U.S. equity strategy at Morgan Stanley, has a different take on energy and industry sectors. He sees the dramatic decline in energy prices as “a net-net good for the S&P 500,” and consumer-discretionary stocks as “a clear beneficiary,” especially as expectations are falling.
Parker likes companies such as L Brands (LB), whose Bath and Body Works and Victoria’s Secret brands have broad appeal. He is also a fan of Macy’s (M), which might benefit if consumers feel stronger financially.
ARE THERE BARGAINS in beaten-down energy shares? Views are mixed in our group, with three strategists favoring the sector and one advising avoidance. Valuations are attractive, says Citi’s Levkovich, but “you need oil prices to stabilize.”
Auth, of Federated, thinks that crude could rebound to the $90s in the second half of 2015. But he warns that energy prices could go even lower in the short term on supply and demand dynamics, and notes that “the stocks don’t go up when oil goes down.”
Parker, like Levkovich, sees compelling value if oil prices stop falling. “I see a lot of fear in energy,” he says, citing Schlumberger (SLB) as a high-quality oil-service outfit that is trading at an inexpensive valuation. Schlumberger has fallen 32%, to $80, from its midyear peak, and trades for 14 times fiscal-2015 earnings estimates. The stock yields 2%.
Subramanian recently downgraded energy to Market Weight from Overweight. If investors want to prospect in the sector, she advises looking to big, underowned, high-quality energy names that are less sensitive to short-term fluctuations in oil and pay generous dividends. ExxonMobil (XOM) meets all those criteria. Its shares have tumbled to $86.60 from $104, and yield 3.2%.
David Kostin, Goldman Sachs’ chief U.S. equity strategist, sees a bifurcated year, with GDP growth pushing stocks up in the first half, but an interest-rate hike dimming investors’ appetite for equities thereafter, and leading to multiple compression. He applies a multiple of 16 to his 2016 S&P 500 earnings forecast of $131 to achieve a year-end target of 2100.
Since 1994, Kostin says, the S&P 500 has returned an average of -4%, 5%, and 6%, respectively, in the three, six, and 12 months after the Fed’s “first” rate hike in a cycle. However, the market’s P/E contracted by an average of 8% during the three months following the initial tightening.
Most important, he says, is the debate around the first hike—in particular, discussion of how swiftly subsequent increases will follow. Goldman expects the Federal Reserve to continue lifting the fed-funds rate until it hits 3.9% in 2018, by which time Kostin expects the S&P 500 to be trading at 2400.
Getting the Fed’s moves right in 2015 could be the single most important factor in making an accurate market prediction. Alas, the Street’s strategists don’t have an unblemished record. Last December, they predicted that yields on 10-year U.S. Treasury bonds would rise to 3.4% in 2014 from a then 2.8%. And they weren’t alone; higher yields were the prevailing expectation among most investment professionals.
Instead, the bond market rallied this year, and yields fell as low as 1.87% in intraday trading on Oct. 15. (Bond prices move inversely to yield changes.) Global fixed-income investors embraced U.S. bonds, as yields in Europe and Japan fell to unprecedented lows; German Bunds yield just 0.6%; Japanese bonds, 0.4.%
The case for higher rates is a little stronger than last year,” says Columbia’s Knight. “As the Fed raises the fed-funds rate, short- term bond yields will move away from zero.”
The Fed’s policy-making arm has a median fed-funds forecast of 1.37% at the end of 2015, but the futures market puts the policy rate at about 0.75% by then. “Investors are looking for lower and later rate hikes,” says Dubravko Lakos-Bujas, who became chief U.S. equity strategist at JPMorgan Chase earlier this year. “Should the FOMC make moves consistent with its current estimates, that would be a negative surprise for investors.”
Lakos-Bujas has a 2015 target of 2250 on the S&P 500. JPMorgan Chase expects the 10-year bond to yield 2.8% at the end of next year.
FOR MANY STRATEGISTS, crucial legs of the bull case for equities in 2015 are a stronger European economy and the end of the current recession in Japan. “It’s important that Japan and Europe don’t fall into the tank,” says Knight. “Japan has one foot in.”
Like the U.S., Europe and Japan will both reap the benefits of lower energy costs. Their exports will be cheaper, due to depreciating currencies, and their borrowing costs are low. If Europe avoids a recession and Japan recovers, their bond yields will rise, pushing up U.S. yields, as well.
A further contraction in Europe’s economy could be particularly ruinous, and undermine the bull case for U.S. stocks, says Knight. But the strategists are optimistic that the European Central Bank will follow the Fed’s playbook and announce some sort of quantitative-easing, or asset-buying measures, to juice economic growth. (For another take on Europe, see this week’s Follow-Up.)
Prudential’s Praveen says the ECB is preparing the legal and technical groundwork to be able to buy the sovereign debt of euro-zone nations, which would be a necessary precursor to a U.S.-style QE maneuver.
GEOPOLITICS LOOMED larger in investors’ minds in 2014, especially after Russia invaded Ukraine in late February. The decision last month by the Organization of the Petroleum Exporting Countries not to cut oil production in the face of falling prices also had geopolitical overtones, as the Saudis, who dominate OPEC, sought to keep the pressure on their foes in Russia and Iran, not to mention U.S. shale-oil competitors.
Praveen likens Russia to a caged tiger, and worries that Moscow will strike an even more militaristic pose. “The country is in bad shape, due to lower oil prices, but it wants to remain relevant on the world stage,” he says.
Russia doesn’t have much to lose, and could double down on its aggressive action in the Ukraine, he adds.
China is another concern for anyone trying to forecast markets in 2014. Most observers believe that moves by the Chinese central bank to ease monetary policy will provide sufficient stimulus to help the economy expand by 7% in the year ahead. But a big stumble by the Middle Kingdom could upend bullish forecasts for the U.S. and other markets. The strategists note that nearly all forecasters are building 7% growth in China into their 2015 models.
AMONG INDUSTRY SECTORS, the strategists generally favor information-technology and industrial stocks, as they have in years past. Tech offers growth, and the stocks currently sell for low valuations, says Barclays’ Glionna. Tech outfits are favored for their fat profit margins and clean balance sheets, and will benefit as other U.S. companies boost capital-spending budgets.
Lakos-Bujas, of JPMorgan, notes that tech companies also are more exposed to global markets. While the rising dollar presents a head wind to sales, product demand is relatively inelastic.
Among techs, Subramanian likes Intel (INTC), in part because it has $9 billion of net cash, and because returning cash to shareholders is now part of its corporate ethos. The shares were fetching $36.22 late last week and were yielding 2.4%.
IT HAS BEEN a while since the Street favored financials, although rising interest rates could give the companies—and their shares—a lift. Net-interest-margin spreads will widen if interest rates rise. Moreover, loan growth could improve as the economy grows. Life-insurance companies also benefit from rising interest rates.
At the same time, higher rates would be a negative for utilities, telecom services, and consumer-staples shares. As the most bond-like of stocks, and among the market’s most defensive, as opposed to economically sensitive issues, these stocks are expected to lag behind the market in 2015. Utilities and staples have high valuations, relative to their historical ones, which poses another obstacle to continued gains.
In bull years, the rally is getting old. But recessions, not longevity, typically kill bull markets, says Morgan Stanley’s Parker. To say that age alone is enough to end stocks’ six-year run makes no more sense than using astrology to predict stock prices, he adds. Then again, Taurus is characterized by determination—much like Wall Street’s bull.
