ADAM S. PARKER, PhD
|The US stock market is at an all-time high, earnings aren't projected to grow and the major global economies- including the US, Japan, Europe and China-all appear to be growing less rapidly than experts previously anticipated. Let's take stock of the macro situation and offer some investment ideas.|
Why is the market high but sentiment low? For much of the past few years, we could be accused of propagating, if not captaining, the "bad is good" mantra-i.e., bad economic news is good for markets, as it means policymakers will remain accommodative. However, we do think many investors are becoming worried that bad, at some point, will be just bad. We think the Fed will likely raise the federal funds rate later this year and has tapered its asset purchases. So, less growth and less liquidity can't reasonably be expected to be a multiple expander for the overall equity market, right? Honestly, we think it is this consensus creating the current odd dichotomy-a high market but pretty cautious sentiment.
So why are we still bullish given the overall sentiment is rooted in some real concerns? There are three simple reasons to be constructive:
Bottom-up earnings estimates are too low. The 2015 consensus forecast for the S&P 500 is just over $119 in earnings per share (NYSEARCA:EPS), and we forecast a top-down outlook of $124. It is unusual for bottom-up numbers to be too pessimistic and, in fact, it has happened only six times in the 39-year history of the forward earnings estimates. We think we have already seen the trough in earnings estimates; there were upward EPS revisions in six of 10 S&P sectors during the recent earnings season against a bar that we think had been lowered too far earlier in the year. Going forward, we would not be surprised to see higher numbers in consumer, health care, financials and energy, among other sectors.
The US economy will improve. While the US and global economies have been more tepid than our economists had expected, Ellen Zentner, Morgan Stanley & Co.'s chief US economist, is forecasting an improving economy in the second half of the year, in part fueled by a modest uptick in spending by increasingly confident consumers.
Market sentiment is glum. We think sentiment about US equities is relatively low compared with Europe, Japan or China "A" shares. In our view, US equities remain quite attractive on a valuation basis versus nearly every government bond around the world.
For sure, we think it's too early to call the market's top. Neither the economic data, nor corporate behaviors, nor the health of the credit cycle supports such a move. Our signposts include economic factors like consumer obligations, delinquencies and housing, most of which appear to be improving. Signs of management hubris in the form of capital spending, hiring, inventory and frothy mergers-and-acquisitions (M&A) activity seem, in the aggregate, suggestive of mid-cycle behavior. Capital spending remains relatively constrained, growing at roughly the pace of sales. Inventory doesn't appear to be an impediment to margin expansion, as backlogs aren't swollen and book-to-bill ratios appear steady, which typically means management aggression to attract customer orders is tame. Hiring outside of a few areas remains slow and our judgment is that wage inflation has been primarily limited to the low end. M&A has been largely immediately accretive as opposed to speculative as in prior cycles. While we see a few signs of excess in management compensation and new corporate headquarters emerging, we certainly don't think this is late-cycle behavior. Lastly, favorable financing terms have allowed corporations to push out their financial obligations for several years, making broad near-term credit risk unlikely. We would need to see deterioration in the economic outlook- particularly for the US consumer- increased management hubris, or a burgeoning debt crisis to have increased conviction in a 10%-or-greater US stock market decline.
THE NEXT RECESSION. What will the next recession bring? Recently, there has been some growing concern that when the next downturn occurs, the Fed will have little power to fight it. We have written previously that we don't think unconventional policy-what we've seen in the past six years-will be the medicine during the next cycle. Our view is that the current expansion will be long and the Fed will be able to manage it with conventional policy tools and, looking to the political sector, some fiscal stimulus. Our guess is that there will be a sharp drop in equity markets before there is fiscal stimulus, but the potential positives from such stimulus could be enormous. Tax reform, repatriation, immigration law, infrastructure bills and more-productive spending are among the various positive potential elements of a coordinated fiscal agenda, many of which could fuel a better US market.
For now, we are still focused on this economic expansion, given we think it could last for several more years. The fact that the market has achieved a new high muted economy and this much negativity speaks to how attractive equities are, in relation to bonds, and the potential for US improvement.
LAST YEAR'S LESSONS. As we think about the year ahead, we recall some lessons from last year's two big market movements. In March 2014, Federal Reserve Chair Janet Yellen made some "late cycle" comments that caused a huge rotation out of growth and momentum stocks. Then, in the fall, the oil price halved. Portfolio managers who were overweight growth in the first quarter or energy in the fourth quarter basically couldn't outperform the S&P 500 last year. This year, we have seen a big reversal since the reflation trade began in mid-March.
As we think about 2015, we worry about two areas of the market. One is the growth-stock universe because the HFRX Hedge Fund Index shows exposure to growth stocks at an eight-year high. Our second concern is that investors are clearly overpaying versus history for dividend yield, in the form of high valuations on price/forward earnings, or cash flows for telecoms, utilities, real estate investment trusts, master limited partnerships, consumers staples and other high-yielding securities. As for other potential big moves this year, it seems like selling growth and overvalued dividend-yield stocks and buying energy and financials is a possible path. That's why we are overweight financials and energy, and underweight staples and telecoms (see chart).
Sure, the stock market is high, but expected improvements in earnings and the economy in the months ahead, combined with poor market sentiment now, keeps us in the bullish camp.