If we see higher risk assets further over-valued, do not chase the move, but rather sell into price ...
Lower Your Expectations
07/13/2009 10:55 am EST
Sam Stovall and the rest of Standard and Poor's Investment Policy Committee expect gradual gains for stocks, after a near-term setback. Credit and joblessness are likely to get worse.
It’s that time of year again when Standard & Poor’s Investment Policy Committee issues its fearless forecast for the remainder of the year. During the first half, investors went on a tumultuous ride, as the S&P 500 fell 25% through March 9, then rose nearly 35% through May 8, only to meander between 946 and 895 since. We now have a target for the S&P 500 through June 2010 of 1015, an implied 13% 12-month price gain, which translates into a 955 year-end 2009 target.
Our three-to-12 month investment outlook is positive. We believe the bear market, which sliced 57% from the value of the S&P 500, ended on March 9, 2009; the longest and deepest post-war recession will conclude by the fourth quarter of 2009; year-over-year changes in S&P 500 profits will stop declining by the end of the year; stocks will outperform bonds; small caps should outpace large caps; cyclical sectors may again be relative outperformers versus defensive ones; and even though past performance is no guarantee of future results, the S&P 500 should rise over the next 12 months.
We are cautious over the next three months. Here are some of our concerns: The S&P rose 40% from March ninth to June 12th, more than any recovery rally except after the 1929-32 crash. It retraced 30% of what was lost in the preceding bear market, versus 18% in 1932. A digestion of these rapid gains is highly likely. History suggests an almost 10% to 15% decline to the 800-850 area for the S&P 500. Current valuations hardly justify significant upside, in the near term.
Second-quarter profits for the S&P 500 will likely fall 17%, year-over-year. Recent S&P equity analysts’ revisions point to reduced expectations.
The average projected 12-month P/E during all market cycles since 1999 was 17, according to ThomsonOne. Today the S&P 500 is at 23 times trailing 12-month earnings and 17 times 2009 estimates. There is a very wide disparity between top-down and bottom-up 2010 profit estimates. S&P Economics forecasts 2010 earnings per share (EPS) at $46.60. S&P equity analysts see $74.10.
The economy is no longer in freefall, but we aren’t at the bottom yet. We expect the recession to end officially in the fall, but the subsequent recovery is likely to be sluggish, with the unemployment rate not reaching a peak until mid-2010. We think inflation shouldn’t be a problem until the economy recovers, despite the recent hype.
Looking out one year, the picture is muddied by a higher-than-average degree of uncertainty in corporate earnings estimates. S&P analysts remain sanguine on 2009 corporate earnings prospects, partly due to a stronger dollar, and muted spending as consumers focus on savings to replenish wealth lost in housing and the stock market. With a stronger uptick in economic growth not likely until late 2010, a six-month prior response by the market would lead to sustained higher equity prices around the second quarter of 2010.
We think Treasury yields are in the process of peaking out. During the next two to four months, we could see the ten-year yield decline towards the 3% to 3.3% area. Treasury bond prices have recently cycled into an extreme oversold condition on a daily basis, and also have become oversold on a weekly basis. In addition, sentiment has gotten very bearish towards Treasuries of late. From a contrarian viewpoint, we think this is bullish. Treasuries are, of course, a defensive asset class that may benefit from the corrective action we expect in the stock market.
Crude oil prices have pulled back from their recent highs. If we do see a correction in the stock market later this year, we think crude will fall as well, possibly back into the $50 to $55 range.
The current market will not be supported by vast mutual fund flows returning to equities, in our opinion. Investor flows into equity funds tend to follow returns. However, after the declines in the stock market since the market peak in October 2007, fund investors, and in particular, those nearing retirement, have been reconsidering their tolerance for risk and moving heavily into fixed income funds.
US corporate credit quality remains at greatly deteriorated levels, marked by elevated pressure across nearly all credit measures. From the perspective of rating changes, downgrades have outpaced upgrades among US financial and non-financial firms at a ratio of nearly 5:1 over the past 24 months, roughly twice that of the 15-year average of 2.4:1. In fact, this downgrade-to-upgrade ratio in the past six months is at an unprecedented level of nearly 11:1. These levels are expected to continue to rise, particularly in the United States, as negative bias for financials and non-financials of 40% and 37%, respectively, outpace their 15-year-averages of 24% and 26%, respectively.
Considering all of this is occurring in a default cycle characterized by unprecedented financial stress and a more toxic ratings mix than any other point in history, we expect that the current US speculative-grade default rate of 8.13% will rise to 14.3% by the end of the first quarter of 2010, and an increase beyond the forecast horizon is likely.
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