Sam Stovall: S&P's Mid Year Outlook

07/14/2015 10:00 am EST

Focus: STOCKS

Sam Stovall

Chief Investment Strategist, CFRA Research

Looking at the first half of 2015, economists have been quick to dismiss the year’s slow start, telling investors that the remainder of the year will likely be a repeat of what happened in 2014. But will it? asks Sam Stovall, managing director of US Equity Strategy for S&P Capital IQ.

Tailwinds to an advance include low inflation and interest rates, even after the expected start of the rate-tightening cycle, as well as a projected “V-shaped” recovery in EPS.

However weakening economic growth expectations, elevated valuations, international tensions, and the maturity of this bull market remain headwinds.

So what do investors have to look forward to? Here we look at several aspects of the economy for hints about the future.

Judging from the first half of 2015, economic growth is expected to be slower this year than last; S&P 500 profit growth will have difficulty keeping its head above water; forward 12-month valuations are nearly 10% higher than a year ago; and the value of the US dollar is 20% above where it was last year.

Capital IQ expects S&P 500 EPS to decline 0.5% in Q3 on the heels of a projected 4.2% falloff in Q2. Nine of 10 sectors saw reductions to Q2 estimates, while eight of 10 had their Q3 estimates cut and six of 10 estimates for Q4 are currently lower than they were at the beginning of the prior EPS reporting season.

Based on the “Rule of 20” and other factors, S&P Capital IQ’s Investment Policy Committee has a 12-month target price for the S&P 500 of 2250.

After reducing our US equity exposure, we now suggest a 60/40 exposure to stocks and fixed income, with a neutral exposure to US (45%) and foreign stocks (15%), an underweighting of US bonds (25%), and an overweighting of cash (15%), citing soft seasonality, the transports diversion, and high valuations.

Among sectors, we favor the Healthcare, Industrials, and Tech sectors, while suggesting underweighting the Materials, Telecom, and Utilities groups.

From an historical perspective, the S&P 500 has upside potential through 2015. In the third year of presidential cycles, the 500 rose an average 3.7% in the second half of the year and increased in price 71% of the time.

Meanwhile, the S&P 500 has gone 44 months without a decline of 10% or more, versus a mean of 18 months and a median of 12 months since WWII.

EPS growth and inflation expectations point to a positive close for the year, however modest the gain might be. The Rule of 20 says if the P/E on the S&P 500 plus inflation equals 20, the market is fairly valued.

Since Capital IQ aggregate EPS estimates point to $118.52 for all of 2015, this model implies that the S&P 500 has the ability to rise to 2145, or so, by the end of the year.

Our 12-month target for the S&P 500 is 2250, which is a median of S&P Capital IQ’s Investment Policy Committee members’ 12-month forecasts.

After reducing our US equity exposure earlier in the second quarter, we are now recommending a 60% equities/40% fixed income portfolio for the average balanced investor.

We also suggest a neutral exposure to both US (45%) and foreign stocks (15%), but suggest underweighting US bonds (25%) while overweighting cash (15%), in light of soft seasonality, the diversion between the industrials and transports, as well as high valuations.

Should the Fed increase interest rates later in 2015, it will be because they believe the US economy is strong enough to withstand up to two rate increases by yearend.

But higher rates will still likely slow growth as an expected firming of the US dollar should act as a drag on exports.

So, there you have it. History says the S&P 500 may see a sub-4% price gain the second half of this third year of the presidential cycle. The Rule of 20 also says we could see higher prices, but limits it to only 1%.

S&P Capital IQ remains bullish, but with a lower-case b and recommends a neutral stance, advising not trying to time the next top, while also not going too far out on the risk curve.

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