S&P’s Mid-Year Investment Outlook
Through June 15 of this year, the S&P 500 rose 8.1%, all 10 sectors in the “500″ were in the black, and 80% of the 130 sub-industries gained on the year. In addition, 52 groups recorded double-digit gains, while only three sub-industries fell by 10% or more: gold, homebuilding, and motorcycle manufacturers.
Should the S&P 500 rise for the entire month, the index will have advanced in 16 of the last 18 months, with only May 2006 (down 3.1%) and February 2007 (off 2.2%) in the red.
This market breadth, strength, and longevity have left analysts scratching their heads and asking, “Why have equity prices strengthened, when fundamental factors have weakened?”
In the past three months, oil prices increased by $10 a barrel, yet stock prices climbed. The forecast for the first Fed rate cut was delayed to the first quarter of 2008 from the third quarter of 2007, yet stock prices climbed. The yield on the U.S. 10-year note rose to 5.25% from 4.65%, yet stock prices climbed. The full-year operating earnings growth estimate for the S&P 500 fell to 7.3% from 9.6%, yet stock prices climbed. The S&P 500’s P/E on trailing results expanded from 15.9 times to 17.1 times, yet stock prices climbed.
In the past six months, the market appears to have blissfully bypassed events that individually could have triggered a selloff, yet collectively have been treated as non-events. Are we missing something? It’s possible in the near term, but most likely not in the longer term.
Mark Arbeter, S&P’s chief technical strategist, says the S&P 500 should be able to make a run at the 1540 to 1560 zone fairly soon. Should the market break above that level, we believe it has a good chance of extending gains into the 1575-1625 area. Arbeter thinks a lot of individual investors are still watching from the sidelines and may regret missing out on this rally, thus extending the time and magnitude of the eventual advance.
Longer-term, however, S&P’s Investment Policy Committee (IPC) believes the market will not likely be willing to accept additional risks this late in the market and economic cycles, particularly in a period of decelerating earnings growth. As a result, it has maintained its year-end 2007 target for the S&P 500 at 1510, 6.5% above the closing value of 1418 in 2006, and 2% below today’s level. GLOBAL ALLOCATION RECOMMENDATION
More important than a year-end target, in our opinion, is the appropriate asset allocation. Our IPC benchmark (”all things being equal”) allocation suggests that a typical “balanced” investor have a 60% exposure to equities and a 40% exposure to bonds, also known as fixed income, and cash. Within the equity holding, we typically suggest a 45% exposure to domestic equities and a 15% exposure to foreign stocks. Within fixed income, we normally recommend a 30% weighting in intermediate-term bonds and 10% in cash. Based on our current view of domestic and foreign equity and fixed income markets, we are suggesting a slight underweighting of U.S. stocks and an overweighting of international equities, as well as an underweighting of an investor’s bond portfolio. Specifically, our current allocation calls for 40% in U.S. equities, 25% in foreign stocks, 25% in bonds, and 10% in cash. UNDERWEIGHT U.S. EQUITIES, OVERWEIGHT INTERNATIONAL
Even though U.S. equity prices continue to be supported by M&A activity (S&P Capital IQ reported that through June 18, global announced and closed M&A transactions surpassed $2.1 trillion, ahead of the 2006 year-to-date figure by 57%) and share buybacks, we believe foreign equities will be relative outperformers. HIGHER RATES, LOWER BONDS
We recommend underweighting bonds, as we see the yield on the 10-year Treasury note rising in the next 15 months. David Wyss, S&P’s chief economist, projects the yield on the 10-year note to close 2007 at 5.22%, and then rise to 5.55% by the third quarter of 2008 and remain at that level during the rest of the year. But he believes the rise in U.S. rates will have more to do with the repatriation of foreign investments in search of higher yields closer to home than he does a pickup in the rate of U.S. inflation. He forecasts core CPI to advance by less than 2.25% in each of the coming three years. He thinks core inflation is under control and reminds us the PCE deflator is up only 2.0% from last April, and now sits atop the Fed’s “inflation comfort zone.” He expects the Fed to delay cutting rates until early 2008, since the unemployment rate remains low, and thinks any early move would be a hike, caused by an upside inflation surprise.
