What's Next After Dow 12,000 and S&P 1,300?

02/03/2011 4:00 pm EST


Howard Gold

Founder & President, GoldenEgg Investing

On Tuesday, the market hit a double milestone: The Dow Jones Industrial Average closed above 12,000, while the Standard & Poor's 500 index finished the day over 1,300.

The move came after a powerful five-month advance and, for the Dow at least, the best January since 1997.

But S&P 1,300 may have been more significant: Technicians regarded that as a key resistance level. If the S&P can stay above it for a few trading days—and it slid back below that landmark in Thursday's trading—it could head even higher.

That would be good news for a rally that's been looking a bit long in the tooth lately. After a two-year bull market that has seen the S&P nearly double—it needs to get to just 1,334 to do that—there are big questions about how much longer it will last, how much higher it will go, and—most importantly—which stocks are going to do best now.

For that, I turned to Sam Stovall, chief investment strategist at S&P Equity Research. He recently updated his forecast for 2011, based on expectations for stronger earnings and a healthier economy in 2011.

“The [earnings] growth forecast for 2011 is 15%,” he said in an interview. “As the Beatles' song goes, 'It's getting better all the time.’ ”

3 Reasons for More Optimism

Stovall is using a $96-a-share “bottom-up” analysts' estimate for S&P 500 earnings for 2011. In the past two months, it has gone higher, he added.

In December, Stovall predicted the S&P would reach 1,315 this year, but he recently upped that significantly, too. “Our new target is 1,370. We're looking for about a 9% price appreciation for the full year,” he told me.

That's about in line with the projections of 11 market strategists polled by Bloomberg News. (Uh-oh, the contrarian in me says.) It's also a reasonable 14.3 times his projected S&P earnings for 2011. Stovall's optimism is based on three factors: a better economy, stronger earnings, and the favorable timing of the presidential election cycle—the same things I cited last August as reasons to buy stocks.

Since 1945, the S&P has gained an average 17.1% in the third year of a president's term, Stovall found—and the three very best quarters in the four-year presidential cycle were the fourth quarter of the second year through the second quarter of the third year. In other words, right now.

And this bull market appears to have more room to run.

What Profits Next

Since 1932, Stovall's research found, bull markets have averaged 45 months—or 3 ¾ years. The bull market of the 1990s, of course, encompassed nearly a decade, while others were much shorter. But all ten bull markets since 1949 have lasted three years or more, he says, so we most likely have at least another year to go.

There are reasons to think it might last even longer. First of all, the hangover from the financial crisis and the housing bust has slowed the economic recovery and made it weaker than normal. Only in the last few months have we seen the kind of rebound in economic activity that we usually experience in a cyclical economic recovery. That means the entire cycle may be more stretched out this time.

So, which stocks and sectors will do well now?

Last year Dirk Hofschire, vice-president of Fidelity's market analysis, research, and education group, did an extensive study of which sectors do best at different points in the economic and stock market cycle. (He also included a nifty tool that helps investors select the right sectors at the right times.)

Stocks begin rallying before a recession ends, and the early stage both predicts and reflects the nascent recovery. Interest- and economically sensitive sectors like financial, consumer discretionary, technology, and some industrial stocks tend to outperform.

We're pretty much through this phase. “It appears the early-cycle market phase ended sometime in the first half of 2010,” Hofschire wrote. “The best performing sectors were typical early-phase leaders such as consumer discretionary, industrials, financials, and technology.”

The market now seems to be in the “mid-cycle phase,” when, according to Hofschire, “a shift takes place toward some industries that don't tend to see a peak in demand for their products or services until the expansion has become more firmly entrenched.”

Which ones are those? Energy, materials, and industrials assume market leadership 71% of the time during this phase, he found, and technology also performs well.

Stovall agreed. “Energy, industrials, and technology have been the best-performing sectors in January, and they're likely to do well the rest of the year,” he told me.

The Cream of the Crop

In the energy sector, he likes Chevron (NYSE: CVX), while among materials stocks he prefers Ball (NYSE: BLL). Jacobs Engineering (NYSE: JEC) is a favorite in the industrial sector, and software stalwart Oracle (NYSE: ORCL) gets a thumbs-up among tech stocks. All four of these stocks get high S&P STARS scores, as well as high quality and fair value rankings.

Some ETFs that cover those sectors are the Materials Select Sector SPDR (NYSEArca: XLB), Vanguard Energy (NYSEArca: VDE), Industrial Select Sector SPDR (NYSEArca: XLI), and iShares Dow Jones US Technology (NYSEArca: IYW).

So, when will we move into the final phase of this bull market? According to Hofschire's model, that usually doesn't happen until the Federal Reserve starts raising interest rates. With the Fed still committed to “quantitative easing”—i.e., pumping money into the system—I don't see that occurring until very late this year or 2012 at the earliest.

That's why the midcycle phase may be more protracted than usual this time, and the late phase, which usually presages the next recession, may be delayed. So, if you're an active investor or closet market timer, I'd hold off buying health care, utilities, consumer staples, or other late-stage defensive stocks until you see the whites of the Fed's eyes.

As I wrote in my “predictions” column in early January, I'm looking for a significant correction this year—most likely tied to some external shock, like another European debt crisis. I have no idea when that might happen.

And I have no idea how long the current bull market will last. But based on market history and the laws of economics, we look like we have some time before we'll start singing, like the late Don Meredith, “Turn out the lights—the party's over.”

Howard R. Gold is a columnist for MarketWatch and editor-at-large for MoneyShow.com. He does not own any of the stocks or ETFs mentioned in this column.

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