Sam Stovall on 'Sell in May' and Navigating the Year Ahead

Includes: DIA, EEM, QQQ, SPY
by: Benjamin Shepherd

With the Dow Jones Industrial Average once again above 11,000 and the S&P 500 up more than 60 percent from last year’s low, many investors are beginning to wonder if stocks are overheated and due for a correction. We spoke with Sam Stovall, chief investment strategist of Standard & Poor’s Equity Research Group, chairman of the organization’s Investment Policy Committee and author of The Seven Rules of Wall Street. Sam shares his current take on the market and discusses how an old adage can help nervous investors preserve capital if the markets correct.

A lot of folks wonder if the markets are overvalued. What does history say?

That depends on your reference point. With the S&P 500 over 1,200, the price-to-earnings ratio [PE] is 18.9 based on trailing fourth-quarter operating earnings--a 2.6 percent discount to the average PE since 1988. If this marks the early innings of a bull market, expect investors to be more forgiving of valuation in anticipation of earnings improvement.

What about reported earnings? Including the current quarter, the S&P is trading at a PE of 23.6 on a trailing 12-month basis. That’s a 9.5 percent discount to the average of 26 since 1988.

If you’re a Michener reader and want to go back to the beginning of time, stocks look expensive. The average PE since 1936 is 17; based on that measure, stocks currently trade at a 40 percent premium.”

From my perspective, stocks are fairly valued right now based on operating results. The S&P 500 could inch up to 1,250, but anything beyond that would be a stretch.

What’s your take on first-quarter earnings?

I’m generally positive. We recommend an overweight position in equities relative to our normal benchmark of 60 percent stocks and 40 percent bonds. Right now we advise allocating 65 percent of your portfolio to stocks, 30 percent to bonds and 5 percent to cash.

We’re in the beginnings of a bull market. The past 60 years suggest that we shouldn’t expect a bull market to die in its second year, though it has happened in the past 100 years. But the average total return is 18 percent in the second year, versus 38 percent in the first year. Cyclical sectors tend to beat defensive sectors in year one, but the magnitude of outperformance usually diminishes in year two. The same goes for small-cap stocks, which decidedly outperform large- caps in the first year but weaken a bit in the second.

We expect the economy to grow at a slower pace than usual in the first year of an economic expansion. Granted, our economic forecast grows more bullish with each passing month. We expect the S&P 500 to post operating earnings of $78 this year. Even if you shift the PE to 17 (the long-term average), that would justify the S&P 500 hitting 1325.

Your outlook is quite optimistic. What could go wrong?

Many things could go wrong. For one, the economy might suffer a double-dip recession as the government removes stimulus measures -- that’s what happened in the early 1980s. Or perhaps the US economy holds up well, but Europe’s developed economies suffer after bailing out Greece and other debt-laden nations.

Corporate earnings could disappoint if underlying sales fail to pick up in the wake of cost-cutting measures. From a technical standpoint, only a few bull markets since the 1930s have been as powerful as this one. The current rally resembles 1932, but the 121 percent gain ushered in by that bull market was followed by a loss of over 40 percent. It would certainly be a blow to sentiment if history were to repeat itself.

Historically, the second year brings an average correction of 10 percent; a decline of 10 to 15 percent wouldn’t be out of the ordinary.

What do I think will happen? I expect the domestic economy to continue to grow, though unemployment will take longer to turn around. Perhaps the economy will grow a little more than 3 percent in 2010, which is less than the 5 to 6 percent expansion that’s typical in the first year.

Profit-taking could initiate a pullback of 10 to 15 percent, but I don’t foresee a new bear market this year.

Should investors be overweight or underweight US equities relative to international stocks?

For US investors, we recommend a slight overweighting of US stocks as well as a slight overweighting of international equities, particularly emerging markets. We estimate that the Chinese economy will grow 11 percent this year and India’s gross domestic product [GDP] will increase 8 percent. As I stated earlier, we expect the US economy to grow 3 percent.

Those economic forecasts won’t surprise anyone. The real question mark involves the direction of the US dollar. We believe the US dollar will decline in value over the next 18 months because of the nation’s rising debt.

That being said, the dollar’s path is uncertain in the near term because of the flight to safety catalyzed by the situation in Greece and concerns about Goldman Sachs (NYSE: GS).

Small-cap stocks would benefit if the dollar stays strong in the near term; these businesses generally lack international exposure and wouldn’t suffer headwinds from dollar appreciation.

Which sectors look appealing right now?

We recommend overweight positions in technology, industrials and health care.

We like the earnings growth potential technology names offer and how the sector typically performs at this point in the economic cycle. Tech stocks usually do well even when the Federal Reserve raises interest rates; these companies traditionally have low debt loads, so interest expense is less of an issue. When interest rates head higher, companies might not add staff but often add computing power to improve productivity and competitiveness.

We like industrials because they tend to perform well later in the cycle.

Health care stocks face less uncertainty now that the reform bill has passed. Plus, in the event of a market correction, this defensive sector should hold up relatively well.

The Consensus Poll surveys technical and fundamental forecasters, strategists and analysts. The most recent reading indicates that 75 percent of the financial professionals polled are bullish; the last time sentiment ran that high was October 2007, the height of the previous bull market. This optimism could lead to complacency and a stumble. In that event, leaning toward one defensive sector isn’t a bad idea.

Have consumer-discretionary names run out of steam?

I believe investors should have jumped into consumer-discretionary stocks in the early part of this bull market move. If everyone agrees that the consumer is likely to fare better than expected, everybody who wants to play this trend has already made their move at this point.

Let me clarify: I’m not saying that investors should underweight the consumer discretionary sector, but we don’t expect the group to outperform.

What other sectors should people avoid?

We expect the financial sector--which is up 150 percent--to keep pace with the market over the next 12 months in the best-case scenario. Also, there is still the potential for onerous regulation.

At present, we have underweight recommendations on traditionally defensive sectors: telecoms, utilities and consumer staples. We won’t maintain that underweight forever, but this stance has worked thus far.

I would remind nervous investors of the old adage, “Sell in May and go away”--a rule of thumb I discuss in The Seven Rules of Wall Street.

Unlike many idiomatic expressions, this one has merit. The market has historically produced better returns from November to April than from May to October.

Since 1945 the S&P 500 has gained an average of 6.6 percent in the first period but only 1.4 percent in the second period.

There’s no guarantee that this logic will hold every year, but this pattern is fairly consistent over the long term. That being said, 1.5 percent over a six-month period is better than keeping your money in cash.

Perhaps the rule needs some modification. A look back at the S&P 500’s historical performance indicates that staples and health care names consistently fare better from May to November.

This pattern isn’t because people usually get hip replacements in May but still makes sense within the context of the market. Investors gravitate toward defensive areas when the market trades sideways, hiding out for more powerful moves in November to April.

If you made a habit of investing in the S&P 500 from November through April and then rotated into health care or consumer staples from May through October, these semiannual rotations would put you up 4.5 percent on the S&P 500 over the past 20 years.

The upshot is that if you’re nervous in a rising stock market, shift to defensive names--you’ll still do better than cash and could outperform if investors gravitate toward safety.

What’s your best advice for navigating the next 12 months?

Market declines are a natural part of any bull market. Unless we expect any sell off to exceed 40 percent, history shows that we will likely recover everything we lost in less than 12 months.

Seventy such market declines have occurred since World War II, and the market has recovered its losses in an average of four months.

I would regard any weakness as a buying opportunity rather than a reason to get nervous.

Disclosure: No Positions