Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: In this week’s Sector Watch report, you discussed asset allocation and indicated that, generally speaking, investors would want half of their portfolio in equities right now. Can you break down that allocation for us?
Stovall: Generally, we recommend a 60-40 split between stocks (domestic and foreign) and bonds for investors. However, we recommended to investors on June 5 to add 5 percent of their exposure to domestic equities, going to 50 percent from 45 percent. We recommended increasing their equity exposure because our feeling is that bonds look so unattractive right now, and we think stocks have another good 10 percent to go on the upside.
In addition, we also recommend that investors have 15 percent in foreign stocks, for a total of 65 percent exposure to stocks. We reduced our recommendation for cash exposure to 10 percent from 15 percent, with the remaining 25 percent in fixed income.
EQ: Obviously, the final strategy could vary depending on each investor’s profile, but that you’re seeing a lot of favorable historic and economic trends to support that outlook. Can you tell us of some of the more compelling ones to you?
Stovall: What I laid out in our mid-year investment outlook report was that historical indicators point to further upside. It’s the fifth year of a bull market, and that historically has led to a 21-percent advance. We also had a very favorable start to the year, with January and February being up, and that has a very strong track record of a positive full year.
We had good momentum in the first half, and that historically leads to even better momentum in the second half. This is then followed up by our expectations of an improving economy and continued growth in corporate earnings, as well as valuations still being attractive, coupled with positive technicals.
So historical, economic, fundamental, and technical indicators still point to a higher market.
EQ: Not all sectors are the same, and investors looking to deploy capital into the stock market also need to understand the different layers and areas as well. Which sectors and markets would you lean toward, and which to avoid?
Stovall: There are 10 sectors in the S&P 500, four of which are your traditional defensive sectors: Consumer Staples, Health Care, Telecom Services, and Utilities. The remainder are cyclicals. Right now, we are cyclically biased, which means we have overweight recommendations in Financials and Consumer Discretionary.
We also have an overweight recommendation on Health Care because we think that group is the more cyclical of the defensive areas. Health Care also represents good earnings growth prospects and attractive valuations.
We’re currently underweighting the Telecom Services and Utilities areas because they have such high dividend yields that they end up being bond substitutes. Also, their valuations still look relatively stretched even after the near 6-percent decline in that market through the latter part of June.
We also have an underweight recommendation in Materials. Even though this group has seen a bit of a pop recently, we still are pretty suspect of the growth prospects in the emerging markets, which is where much of the demand for Materials comes.
EQ: As strong as the economy has looked for the most part, there are some looming concerns as we head deeper into the second the half that could, at the very least, create some volatility in the market. The housing recovery is a big issue to pay attention to, as well as the impact of the sequestration cuts on the economy. Do you see those two issues as the most significant domestic headwinds right now?
Stovall: I think they’re certainly important aspects of our economic story. We think housing will actually continue to provide a tailwind. We’re still looking for good growth in residential construction, and we do know that every new home sold represents two or three new jobs being created that are related to homebuilding as well as household products and services. So our outlook is still fairly positive for homebuilding.
I would tend to say that we do have to be very watchful of the government and the sequestration. Our expectation is that something will be resolved in the third quarter of this year. However, if Congress maintains its stalemate on the issue, that could actually bring our 2.4 full-year GDP growth down to as low as 2.0 percent because of the sharp cutbacks being efficiently positioned, and the effect it will have on unemployment.
So housing will remain a tailwind in our opinion, but the unknowns surrounding sequestration could represent a bigger headwind than some investors are already expecting.
EQ: Last week in our interview, you mentioned that there were likely still too many investors waiting on the sidelines in hopes of buying on pullbacks and minor corrections. That seems very much the case as July has already seen $27 billion in inflows so far, surpassing any other month this year to date. Does this sideline money serve as sort of the cavalry for bulls and long-side investors?
Stovall: Yes, I think it does. There is awful lot of money still on the sidelines. Also, there is money currently in the fixed-income side that could likely go into the equities side of investors’ portfolios. So while money coming in from cash will help, it will help even more when it starts to shift away from bonds and into stocks. This unloved bull market will probably remain unloved for some time to come.