After spending most of 2012 fretting about the weak U.S. recovery, high unemployment and the impending electionnot to mention the long-running debt drama in Europeby December many on Wall Street had settled down to expectations of a not-too-bad 2013. Most see the recovery continuing, and prefer stocks to cash and bonds.
Certainly, all were still eyeing Capitol Hill warily, waiting to see if Congress and the President would drive the country off the "fiscal cliff," a combination of automatic spending cuts and tax hikes set to be triggered January 1, almost certain to plunge the country into recession.
However, most had concluded that a drop off the cliff was unlikely. More likely, the negotiations would drag on into January, when both parties would eventually make enough small compromises to assuage the runaway deficit for the short term. Various strategists dubbed this outcome a mere fiscal "bump," or "bungee jump," meaning it would still cause an economic slowdown, but a much smaller one than if no agreement were reached.
Economists' consensus for GDP growth in 2013 was around 2% in late November, but looked to be edging lower amidst worries about the cliff. Meanwhile, most analysts expected policy makers to push the real task, a substantial overhaul of entitlements, off to some time in the future, perhaps the next Congress.
Yet observers had become so accustomed to the problems that they viewed them as "annoyances to resolve, rather than obstacles to fear," in the words of Sam Stovall, Chief Equity Strategist at S&P Capital IQ.
By late November 2012, the S&P Capital IQ investment committee was forecasting the S&P 500 would climb 10% over the next 12 months. The committee predicted a year-over-year growth in global regional GDP, saying that most regions would have already hit their nadirs in growth by New Year. "On the whole, worldwide growth likely bottomed in Q3 2012, whereas the U.S., because of the effects of Hurricane Sandy, will likely see its trough in the fourth quarter," Stovall wrote in a report. He also believes the slowdown in the S&P 500's profit growth ended last summer.
Now, S&P Capital IQ is forecasting that operating earnings-per-share will climb throughout 2013, posting gains each successive quarter. Although the estimates could be revised downward, Stovall believes that would likely only happen if many other factors, including global GDP growth, got dramatically worse.
Although the market has rallied strongly from its lows and is no longer a bargain, many commentators say valuations are still attractive. As of November 23, the S&P 500 was trading at 13.9 times trailing 12-month operating EPS. That's a 22% discount to the norms since 1988. If you look ahead, the S&P 500 is trading at 12.4 times projected 2013 operating earnings, a 31% discount to norms.
But, not all observers think it's safe to assume that companies won't lower 2013 earnings guidance in the face of looming tax hikes that could slow growth. Some, like Stephen Biggar, S&P Capital IQ's head of global equity research, point out that companies lowered forward expectations in the third quarter of last year as cost cutting couldn't keep offsetting feeble revenue growth. "This trend is likely to continue, in my opinion," he wrote.
Yet, others say the economy has turned a corner. Jim Paulsen, chief investment strategist for Wells Capital Management, argues that despite the slow pace of the recovery, its character broadened considerably in the last year, making it more robust, and less vulnerable to external shocks. He points to a laundry list of hopeful signs in the past year, including stronger jobs figures, climbing consumer confidence, rising home prices and housing activity, plus a revival of bank lending. The consumer's balance sheet is improving, too, and household debt is declining. What's more, there's much less panic in the stock market. The VIX volatility index has dropped and stayed relatively stable. He is also bullish on China and other emerging market economies, arguing their improvement should scupper fears of a global recession, and should boost U.S. exports. In fact, Paulsen thinks things are so much better than Wall Street realizes that the U.S. economy will grow at 3% rather than 2%, this year.
Linda Zhang, a quantitative portfolio manager at MFS Investments, sees signs that the U.S. stocks are undervalued. She notes that the equity risk premiumthe earnings yield over ten-year Treasury yieldis close to 6%, the highest it's been in a very long time, suggesting "a pretty big value displacement" between stocks and bonds.
Jeff Zhang, chief investment officer, active strategies at Mellon Capital, ( no relation) also finds stocks attractive, and says that the continued easy monetary policy from central bankers around the world will provide a lot of support to buoy stock prices everywhere. "We see more upside in the long term," he said. And he advises anyone who's still sitting on cash to seize the day. "If you missed the rally in the U.S. and global markets, and there's a significant correction, this could be a great buying opportunity in the next couple of months," he said.
Linda Zhang of MFS says stocks in developed countries outside the U.S. are trading at a 13% discount to U.S. stocks, a "relative valuation trough" which has happened four other times since 1980. She compared U.S. stocks and non-U.S. developed world stocks over one-, three- and five-years after the valuation trough. Most of the time non-U.S. stocks outperformed, on average by about 12.6% per year.
At a sector level, S&P Capital IQ likes consumer discretionary reasoning that the domestic markets will be less affected by global uncertainty, and will grow in line with the projected 2% pickup in U.S. gross domestic product. The committee also favors healthcare because of its defensive qualities, dependable profit growth and slightly below average price tag. New products, robust emerging market sales and cost restructuring should help offset expiring patents, the rise of generic drugs and European belt-tightening. The committee is steering clear of materials, anticipating slowing global commodity demand thanks to continued weakness in Europe and the BRIC countries (Brazil, Russia, India and China). The committee also dislikes utilities, saying the top performing sector of 2011 is still expensive, and slated to notch weak earnings growth this year. But, for those with income-hungry clients, the sector still boasts impressive dividends.
Which brings us to Wall Street's continuing love affair with high quality, dividend-paying stocks. Even if taxes are raised on dividend income, many experts argue they're still worth it. And it's hard to avoid dividend-payers since they account for 80% of the S&P 500. Further, many believe the worst-case scenario means taxes on dividends will equal that on bonds. Plus, the yield on bonds is so low (around 1.6% in late November) and with the economy likely to recover more strongly, Stovall argues they are more risky to own than dividend-paying stocks. Still, he warns advisors not to blindly go for the highest yield, but to screen for consistent growth as well.
Stovall's picks with yields over 3% include: Darden Restaurants, McDonald's, Altria, General Mills, Kellogg, Lorillard, Pepsico, Chevron, Transcanada, Bank of Novia Scotia, Abbott Laboratories, Johnson & Johnson, Norfolk Southern, Waste Management, Automatic Data Processing, Microsoft, Nextera, South Jersey Industries, and UGI Corp.
This love of high quality dividend payers is shared by Morgan Stanley, which screens for companies which have raised dividend payments for 25 years in a row. Dubbed the "dividend aristrocrats," they include Eccolab Group and Emerson Electric. But dividends are not the only factor. "The key is to look for companies with PE expansion without earnings going down, and that means global exposure," said Charles Reinhard, Morgan Stanley's deputy chief investment officer. The firm looks for large multi-national companies domiciled in a developed economy like Europe or the U.S., that get much of their revenue from the faster-growing developing world. Often consumer brands, these companies benefit from the rising middle class in places like India and China.
Morgan Stanley calls these companies "Global Gorillas" and favorites include Pepsico, Procter & Gamble, Tesco, Nestlé, Inditex (owner popular women's clothing retailer, Zara); as well as YUM!, parent of Taco Bell, Pizza Hut and KFC.
As strategists saw things looking up for stocks, they saw reasons to lighten bond exposure. Indeed, Linda Zhang of MFS argues that bond investors are extremely vulnerable now. If yields climb from their historic lows to the 100-year average of about 5%, bond investors could take a big hit. She calculates if it takes a decade for the 10-year Treasury bond yield to climb to 5%, investors would lose about 2.3% a year, or 20% of their investment over that decade. If the reversion is faster, say five years, investors would lose about 7% a year, or 30% in the five years.
The answer, say bond strategists, is to look to pare down Treasuries, and look to high grade corporate debt. David Leduc, chief investment officer of Standish Mellon Asset Management, said Treasuries will be supported over the first few months of 2013. "It means in the near-term, in a low-growth environment, one where not a lot of stuff is going to diminish the quality of corporate balance sheets, those markets are still attractive in a low-yield world where people are desperate for income." But afterward, when there's more clarity, it will be time to look to emerging markets corporate debt. "There's a lot of alpha there," Leduc said in a recent press briefing.
With all the easy monetary policy bankers around the developed world are using to finance deficits, reinflate their economies and reduce debt liability, they are losing their competitive edge in currencies.
Jeff Zhang of Mellon believes the in the medium term the dollar, euro and yen will depreciate against the currencies of emerging markets, and commodity-rich countries with healthy balance sheets like Australia and Canada. But, he says it's not sustainable and expects many emerging countries will eventually devalue their own currencies to compete. That means currencies around the world will depreciate against real assets. To battle the potential rise in inflation, and bond yields, he prescribes real assets, specifically, private real estate, commodities and commodity-related equities.
So in the final analysis, what will 2013 bring? As Gary Thayer, chief macro strategist for Wells Fargo Advisors put it in a note entitled, "It's Not All Bad," he wrote: "The U.S. economy faces many challenges, but investors should stop focusing only on the negatives and start acknowledging the good things that are happening today."
