Harlan Levy: Now that the first quarter has ended, what's your outlook for the U.S. economy in the second quarter and the rest of this year?
Stuart Freeman: We're looking generally for continuing growth. This may be one of those years where we will see improved growth in both industrials and housing. We haven't seen that since the cycle began. Even though we're not expecting dramatic growth, we're looking for growth to broaden out to more segments of the economy and touch more individuals, as job growth continues forward at a modest pace, with more numbers of people more favorably affected by the benefits of the economy moving ahead.
We've gone through a period where consumer expectations, sentiment, and spending have been rising for some time. So, for the year, we're looking for 2.5 percent Gross Domestic Product growth, and we're looking for $108 in earnings for the S&P 500. Depending on how you want to count last year's operating earnings, we're looking at 5 or 6 percent earnings growth.
We're also continuing to look for global growth. We see modest growth in Europe. Europe is still relatively soft, but we do expect over the next 12 to 18 months a slow rise in fundamentals, also more growth potential in China over that period, but maybe not in the first six months.
This will be one of those cycles where the U.S. is already doing relatively well compared to the rest of the globe, and we expect that in the later portion of this cycle we will see the benefits of international growth benefiting U.S. multinational companies.
H.L.: The stock market had a record first quarter. What do you see in the second quarter and the rest of this year and next year?
S.F.: We just raised our target for the S&P 500 from 1,525 to a range of 1,575 to 1,625. We set the initial range in the fall somewhat conservatively with the fiscal cliff and a breadth of uncertainties, and we feel that we have gone from a dark, black forest into a field with a little more light, less uncertainty, and an economy showing breadth and growth.
We've also seen some movement from fixed income and cash into equities this year, and we're at the point in the cycle where we see broader growth. Investor sentiment, which has lagged behind consumer sentiment, is now picking up, and we see a little more risk-taking. A lot of individuals who were hunkered down in cash and fixed income are having a little less risk-aversion and are just beginning to move toward stocks, and that will continue as we see price-to-earnings ratio expansion. Earnings have been most of the increase in the cycle so far, and we'll see P/E expansion, the basis of our new S&P expectation.
H.L.: Do you see a big sell-off in May after a top in April, the way the old adage goes?
S.F.: We've had a nice move here, a low-volatility move without many pullbacks. The reason for that is that there's a lot of liquidity in the economy and a lot of cash on the sidelines, and the funk from the election, the fiscal cliff, and the budget issues is in the background. Investors have been revaluing stocks, and if we do have a pull back in April or May we think it will be an opportunity to buy.
The market is responding to negative news in a more favorable way than it did last year, a sign individuals are more comfortable with the direction of the economy.
I also think there will be a little more volatility in the next three to five months than we've seen in the last four or five months. We will generally still have a higher market by year-end, but we don't expect the rate of rise to continue because of the volatility rather than the one-way street without volatility that we've had.
H.L.: With all the risky behaviors unfolding in hedge fund and investment bank actions, is the stock market much more dangerous than it seems?
S.F.: There's a lot of talk and some concern about the new highs in the indices, but it's important to point out that we're nowhere near the valuations at the same levels in 2000, at the end of the tech boom with values more than 30 times earnings. And in 2007 the average valuation of the S&P 500 stocks was around 17 times earnings just before the recession. Now we're around 14.5 times earnings with many sectors impacting earnings growth as opposed to one or two sectors. We've had a broad increase in earnings in the marketplace, and that's favorable and reduces the risk of one sector eroding earnings.
As for the relative valuation of stocks versus bonds, stocks are at a multi-decade low valuation versus bonds, even though the S&P 500 is so high. The bond yield is just not very competitive.
H.L.: What sectors do you like and what don't you like?
S.F.: We're leaning generally toward cyclicals. We're overweight consumer discretionaries, because we think we'll continue to see broader spending as the global recovery continues. We're also overweight materials as global growth continues and pricing moves a little higher. And we're overweight technology, because of global growth and current valuations. The sector has been somewhat out of favor. We're also overweight telecom services, although there won't be that much growth, but we like the yields in the area.
We're underweight utilities. They're more defensive, and their earnings tend not to ebb and flow as much with the rise and contraction of the global economy. We're underweight healthcare, a relatively defensive area compared to more cyclical names. It tends to be a little less tied to the economy than the areas where we're overweight.
We're still underweight energy at this level. We could see some moderation there. We're growing moderately, but energy prices may not move the way they have in the past. It's a call on slow growth and the energy prices we've seen so far.
H.L.: How much of a negative factor on the economy is the wide, implacable divide in Congress
S.F.: The budget issue will continue to drive volatility. We have long-term issues, which politicians break down into short-deadline periods. We won't see a lot of progress, and there's a lot of discussion in the media. But I don't think it will derail the recovery or earnings growth. Sequestration was more a slowdown in the growth rate, rather than a general cut in spending, and it's being leveraged in over time, so it hasn't had the impact on the economy that many were fearing. We'll have more deadlines in the future as the politicians work through the budget. We've got a lot of work to do, and I don't think it will be settled in 2013.
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