As Sam Sees It: Debt Ceiling Raise and Strong Earnings Could Drive S&P 500 to 1400.

Sam Stovall  |

Each week, we tap the insight of Sam Stovall, chief investment strategist for Standard & Poor's Equity Research, for his perspective on the current market.

EQ: In your recent U.S. Sector Watch and IPC Notes reports, you wrote that the debt ceiling talks are "high drama and low risk" because the consequences of a U.S. default would be too damaging to the economy for it to actually be allowed to happen. Even so, are you surprised by how the drama is being played out, and especially how the market has responded as the deadline approaches?

Stovall: I would say yes to both those questions. I think that the world appears to be at a stand-still right now, just waiting for Congress to do what it should have done several months ago. In addition, I think investors are wondering if an eventual decision will be enough to avoid a debt rating downgrade.

I'm a little concerned, however, that I'm also hearing increasing rhetoric by strategists that appear to be more accepting of what I think is the unacceptable. These strategists are downplaying the August 2 deadline as the true deadline, are now willing to dismiss the adverse financial reaction should the U.S. credit rating be lowered, and explaining that the U.S. is still the safest bet on the planet.

I find that to be a concern that it's growing in acceptance; that this is now a fait accompli rather than a situation that we should avoid at all costs. That said, I am still relatively encouraged by how the market has held up because when you look at the S&P 500 you think, “Well, where are we right now in terms of price change as compared with where we were on April 29?” We're looking at 1305 on the S&P 500 right now and the percent change is only down 2.3 percent. So the market really hasn't reacted at all to what I think could be a fairly dramatic outcome if the worst happens.

EQ: If Congress can successfully raise the nation's debt ceiling, you expect the S&P 500 to surpass its bull-market high of 1400. But historically, the S&P 500 rises less than average after a debt ceiling raise. What is the difference this time around?

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Stovall: When you think about it, based on Tuesday's close (July 26, 2011) at 1332 on the S&P 500, we're only dealing with one percent in each of the coming five months in order for us to get to 1400 by the end of the year. Also, one percent is only slightly above what we traditionally have seen in the one month after Congress has raised the debt ceiling in the past. Since 1969, there have been 53 times that Congress raised the debt ceiling. The average price increase in the S&P 500 one month after was 0.6 percent versus an average of 0.9 percent for all one-month periods since 1969.

When you look at three months out, the average increase is a little bit less than 1 percent after raising the debt ceiling, but more than 2 percent during all three-month periods since Richard Nixon occupied the White House. We're tempted to say that the performance would be subdued, but even within that subdued framework, we could still surpass the 1363 recovery high and maybe even eclipse that 1400 threshold.

EQ: So, if Congress does fail to raise the debt ceiling in time to avoid a default, which sectors or investment classes do you think will be the hardest hit? Which ones may benefit?

Stovall: Historically, those groups that do the best during bear markets or just whenever investors get really scared are Consumer Staples, Healthcare, Utilities, and a lot of people forget that Energy actually does relatively well. In fact, going back to World War II, those in order were the four best performing sectors on a relative basis. By that, I mean everybody fell during bear markets, but they fell less than the overall market. On average, we also found that Technology, Consumer Discretionary, Industrials and Financials underperformed the market. So those typically would be the areas that investors want to avoid.

If you want to take it one step further and ask what would happen if the U.S. credit rating gets downgraded? Well, we would see sharply higher interest rates, and that would adversely affect those companies that need to borrow on a fairly frequent basis in order to keep their operations going. This is especially true for those companies with long-term debt, because that would raise their interest expense. I used S&P’s MarketScope Advisor Service to compute the median debt-to-equity ratio for each of the 10 sectors in the S&P 500. I found the lowest debt-to-equity ratios to be in the Information Technology, Heathcare and Energy sectors, which all had average DTE ratios of 38 percent or lower, versus an average 54 percent for the S&P 500, and more than 100 percent for Utilities and Telecom.

EQ: Any additional thoughts?

Stovall: I would say that if we do get an 11th hour miracle, which is what we are hoping we will get, our belief is that absolute earnings growth are still expected to be fairly strong. We project 17 percent for this quarter, more than 17 percent for the entire year, and a gain of more than 13 percent for all of 2012. So if we do get past this debt ceiling impasse, then the earnings growth prospects remain very strong for the S&P 500. The valuations, in our opinion, also look fairly attractive. I would say to investors to be prepared for the recovery high of 1363 to be challenged, and maybe even the 1400 level. If the debt ceiling is raised and earnings continue to be better-than-expected, those two factors might help propel share prices in the months ahead.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:


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