2012 Outlook: 5 Unanticipated Potential Stock Market Catalysts

Includes: IEF, SPY, XHB, XLB, XLF, XLI
by: Redwood Investments

2011 Review - Lots of Machinations, No Change

While the US equity market finished the year largely unchanged, it swung wildly in response to the overwhelming wave of macro economic headlines. In fact, the equity markets demonstrated near-record volatility in 2011 driven by macro fears and economic uncertainty. The primary culprit was Europe and its sovereign debt challenges. The PIIGS (Portugal, Ireland, Italy, Greece and Spain) each experienced periods of headline-grabbing interest rate shocks, economic austerity packages, and political turmoil. Political upheaval in the Middle East and the Arab Spring added to global uncertainty. Domestically, a swoon in economic data over the summer combined with a Congressional stalemate and failure of the budget Super-Committee to agree on spending cuts contributed to fears of a double-dip recession.

While most US corporations posted good earnings, the US equity market was not immune to these macro concerns. After appreciating 7% through April, the S&P 500 fell 18% over the next five months, but rallied in the fourth quarter to finish the year unchanged. Volatility was dramatic with the S&P 500 rising or falling more than one percent on 48% of trading days. This heightened volatility made stock selection difficult as macro factors drove stock returns. As macro-economic risks begin to abate in 2012 and the US economy continues to recover, we anticipate that positive underlying fundamentals will become more visible and will set the stage for a more constructive year in which stock selection is effective.

2012 Outlook - Five Unanticipated Potential Stock Market Appreciation Catalysts

Despite macro fears caused by the European debt situation and uncertainty around the 2012 US Presidential election, we are projecting positive catalysts to outnumber negative in 2012. Investor sentiment has been quite negative and may not accurately reflect the strength of actual underlying economic and business fundamentals. For example, in 2011 US companies grew revenues 13% and increased earnings per share 15%. With another solid year of growth forecasted for 2012, US equity markets should generate positive returns in 2012. Our team has identified five possible catalysts that could drive stock market appreciation in 2012.

The Consumer Comes to the Rescue

We expect that consumer spending will continue to improve in 2012 as the US consumer balance sheets have been significantly cleaned up. The Household Debt Service ratio, which is the consumer's interest burden relative to personal income, has declined to its lowest levels since 1994 due to deleveraging and lower interest rates. The yield on the 10-year US Treasury Bond has dropped to a 50-year low of 2%. The initial signs that the consumer is becoming more willing to spend is evident in the Personal Savings Rate, which has slid from 5% during the height of the recession to 3.5% by year end 2011. Strong 2011 holiday retail sales further indicate that the consumer is beginning to spend more. Given that consumer spending represents approximately 65% of US GDP; the consumer could provide a boost to the economy in 2012.

America Goes Back to Work

We expect the unemployment rate will continue to decline in 2012. Despite the 8.5% unemployment rate, the precursors of an improving jobs environment appear evident. First, the Initial Unemployment Claims report, which totals the number of people requesting unemployment government benefits, began declining in 2011 after dramatically increasing from 2007-2010. By the end of 2011, unemployment claims fell 11% from the year earlier period. Additionally, ADP reported the creation of 325,000 private sector jobs in December, more than twice the level expected and the fifth consecutive month of acceleration. Second, Consumer Confidence, a leading indicator for unemployment, has experienced an expansion, suggesting a better labor market in 2012. Third, the ISM Employment Index, which measures whether the labor market is expanding or contracting, consistently exceeded 50 for the past six months. A score of 50 or higher indicates that employers plan to add to the workforce. We believe that an expansion of the US labor market would have a positive impact on the equity markets.

The Housing Market Shows Signs of Recovery

We anticipate that the housing market has bottomed and could begin to improve in 2012. Supply and demand are moving closer to balance due to years of below average new home construction levels. New construction starts have averaged only 600,000 units per year for the past four years compared to the historical average of 1.4 million homes per year. While there is still some excess inventory that needs to be cleared, a pick-up in the number of new homes built in 2012 seems reasonable. In addition, home ownership is more affordable than any time in the past 20 years as measured by the Housing Affordability Index, which hit a record high of 197.8 in the fourth quarter of 2011. This affordability is the combination of lower home prices, lower mortgage rates, and slightly higher personal income levels. Moreover, the worst housing markets during the recession, including California, Las Vegas, Arizona, and South Florida, seem to be stabilizing and could slowly begin to recover in 2012. At the same time, houses are now more affordable than ever, with the rental market demonstrating signs of overheating. Despite a shift of foreclosed and underwater homeowners back into the rental market, rental prices are rising and are at all-time highs as the national rental vacancy rate declined to its lowest level since 2001. The impact of an improving housing market is interwoven through the US economy. Companies in the financial, industrial, and material sectors would experience a tailwind instead of a headwind that could be an unexpected source of economic growth and contribute to equity market appreciation in 2012.

Cash is King

US Corporations have more cash as a percent of total corporate assets than at any time in history. In addition, free cash flow generation is at record levels, which will add to the sizable cash hoards. Importantly, company boards and managements are increasingly returning cash to shareholders in the form of dividend increases, share repurchases, and accretive acquisitions. The percentage of S&P 500 companies that pay dividends jumped from 71% in 2009 to 79% by year end 2011. Moreover, the rate of dividend increases has accelerated with the average company in the S&P 500 raising its dividend 16% in 2011, more than three times the average rate of the previous 25 years. Share repurchase programs are growing. These buybacks have been value-added for shareholders as companies executing repurchase programs have outperformed those that do not by 240bps annually over the past 25 years. This higher percentage of companies implementing buyback programs should boost US equity market returns.

Efficient deployment of cash flow should help stock prices. For example, Macy's (NYSE:M) has used its cash and free cash flow over the past two years to reduce its debt by a third, quadruple the dividend, and initiate a repurchase program. We anticipate that more companies will engage in shareholder-friendly utilization of cash balances and that these actions could positively impact US equity markets.

US Equities on Sale

The US stock market is trading at an attractive valuation that has historically correlated with a subsequent period of strong positive absolute returns for US equity markets. The trailing P/E ratio for the S&P 500 is currently 12x, the lowest level reached since 1990. In addition, the current P/E ratio places the valuation below 70% of time periods since 1948. Other valuation metrics confirming the opportunity for US equities include the price/book ratio (lowest since 1990) and free cash flow yield (highest since 1982). Both 1982 and 1990 represented the start of particularly strong absolute returns for US equities. Further highlighting the attractive valuation levels is a recent research report by Bank of America Merrill Lynch which determined that when equity markets have traded at the current P/E levels, the 10-year compounded annual forward return for the S&P 500 is almost 15%.

The current environment for equities is nearly the opposite from the end of 1999; at that point, equities traded at 30x trailing earnings and 10-year US Treasury Bonds yielded almost 7%. Despite the high equity valuations, record levels of capital flowed into equity mutual funds. Today, investors continue to pour money into bond funds despite the historically low interest rates. Moreover, the yield on the S&P 500 exceeds the 10-year US Treasury Bond for only the second time in the past 40+ years (the other time was at the market lows in 2008/09). While stocks can remain undervalued for long periods of time, the prospects for continued revenue, earnings, and cash flow growth in 2012 combined with the current attractive valuation suggests that investors may soon realize the value in equities.

Consistency, Discipline and Commitment

As 2012 begins, our portfolio team is constructive about the investment environment. While volatility makes predicting short-term price movements difficult, it also provides opportunities for disciplined investors to capitalize on market inefficiencies. The turmoil in 2011 has created a window of opportunity and our portfolio team is eager to exploit it by utilizing our enhanced proprietary quantitative model combined with detailed fundamental analysis. The combination of high quality stocks with strong underlying fundamentals that are trading at reasonable valuations make us optimistic for 2012. We find the current environment to be exciting and we will continue our efforts to build balanced, risk-adjusted portfolios that are designed to outperform over the long term.

Disclosure: I am long M.

Disclaimer: The stocks mentioned in this article do not represent individual buy or sell recommendations and should not be viewed as such. Individual investors should consider speaking with a professional investment advisor before making any investment decisions.