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: President Barack Obama is scheduled to unveil a jobs plan Thursday, reportedly centered around payroll tax relief. Based on what you’ve seen and heard thus far, what is the market hoping to hear from the President?
Stovall: I think the market has already been alerted by the administration as to what they will hear; they just don’t really fully know the scale of it. I think an awful lot of information has already been shared with the general public in terms of the $300 billion stimulus plan–half of which will come from tax cuts, with the rest directed toward infrastructure spending, and direct aid to state and local governments. There may also be some sort of comment regarding the Georgia program, whereby those people receiving unemployment checks will be allowed to train at companies without pay since they’re already getting paid by the government.
The question is, first off, would it go far enough to be able to help pull the U.S. economy out of its malaise? Secondly, what kind of reception is it going to receive from the House of Representatives? Certainly, the Republicans have already stated that the only thing that they want to do is unseat the current president, so you do have to wonder how willing they will be to embrace proposals that are being initiated by the current administration.
I believe the market’s move on September 7 is a snap-back rally from three days of very sharp selling, precipitated by a short-term sigh-of-relief after some of the obstacles to the European debt crisis have been lifted and the market’s anticipation that we might hear something very special Thursday night. As a result, I worry that investors may end up hoping for more from what they hear from the President.
EQ: Do you think this could potentially become a “buy the rumor, sell the news” type scenario?
Stovall: Certainly, that could be regarded as a very cynical viewpoint of what the President says, but I think he faces an uphill battle. Governments rarely pull economies out of recessions directly, it’s usually businesses that finally decide when is the right time to expand. Also, the President will have to face an awful lot of political hurdles in order to get some or much of the proposals passed, which indicates to me that it’ll be business as usual in Washington.
EQ: A few weeks ago, we discussed how the market might have already anticipated future reductions in earnings in spite of what Wall Street analysts’ were estimating. According to the statistics from your most recent Sector Watch report, is it fair to say that analysts actually have been bullish on the market’s outlook this whole time?
Stovall: Analysts have not necessarily been bullish this whole time, because in the summer of 2009, when I looked at where a majority of the Buy recommendations on Wall Street were found, they were concentrated on defensive areas like Healthcare, Consumer Staples, and Utilities. This indicated to me, if everybody bought into the defensive sectors, who’s left to buy and push prices up further or to at least support them? Certainly, the further we went into this economic recovery and bull-market advance, we found that the cyclical stock sectors–the higher beta stocks–were the ones that took the lead. Now, however, it seems as if most people are on the cyclical camp, where it’s the Energy stocks, the Industrials, and the Information Technology stocks, that have the greatest Buy recommendations in general. So, if everyone is crowded on one side of the boat, we might find that they’ll have to soon move back to the other side.
Furthermore, we have not really seen a lot of changes in terms of earnings projections. Earnings estimates for 2011 are still relatively optimistic. S&P Capital IQ reports that consensus S&P 500 earnings projections for 2011 are for more than $100 per share, which is still pretty close to the expected earnings of $98 per share that was expected since earlier this summer. The real erosion has come more from expectations for 2012. Currently, S&P Capital IQ says earnings are expected to be $112 for 2012, which is down slightly from the $113.05 that were projected back in August of this year. So we’re starting to see a bit of erosion in the further out periods of corporate earnings as we move closer to the potential of recession. When you look to the third quarter itself, we’re also seeing that Wall Street analysts are predicting $24.95, where as they had been forecasting $25.30 back in late July. So forward estimates, whether they be quarterly or for outer years, are starting to see a bit of erosion.
EQ: There’s a huge disparity between analyst ratings with an overwhelming majority of stocks having a Buy/Hold rating, and only about 5 percent rated Sell or Weak Hold. If the economy is really struggling through a rough patch, shouldn’t investors see a little more balance in opinion or is this really the buying opportunity they’ve been waiting for?
Stovall: If you don’t believe that we will slip into a recession, and you don’t believe that earnings forecast will be revised lower, then I would say that it is a very good time to be buying stocks. When we look at the trailing earnings for the S&P 500, things are looking pretty good. At current prices, we’re trading at a more than 25 percent discount to the median P/E since 1988, which was when Wall Street started looking at operating earnings. If you look at GAAP (Generally Accepted Accounting Principals) earnings –which have a longer history, and also everybody agrees with how GAAP earnings are computed–we’re looking at a 32 percent discount since 1988, and a near 7 percent discount when you look at the median back to 1936. So even looking at trailing results, the market is attractively valued. The real question is whether we will see the U.S. economy slip into recession. Historically, stock prices have declined an average of 30 percent leading up to recessions and earnings have been reduced by an average of 20 percent. So if history repeats itself, and there’s certainly no guarantee that it will, then I would tend to say that stocks are going to get even cheaper.
EQ: You touched upon this earlier, but can you elaborate further on why it seems like cyclical sectors get so much more love from Wall Street and defensive sectors get such less attention by comparison?
Stovall: Historically, the market goes up 7 out of every 10 years, and if you can stand the volatility, you’re better off being in cyclical high-beta stocks than in defensive low-beta stocks. Since 1990, the best performing sector has been Information Technology, showing a compound rate of growth of around 9 percent as compared to 6 percent for the S&P 500. However, the volatility, as measured by standard deviation, has been about twice that for tech as it has been for the market. So for some people, the volatility looks more like an EKG Diagram. But if you can handle that volatility, then cyclical sectors for the long term might be good places to invest. That could be one reason why advisors in general tend to gravitate towards cyclical sectors over defensive ones.
A second reason could be because, as I mentioned before, valuations look very attractive right now based on price declines, which are anticipating a recession. Obviously, the earnings themselves have not come down because we have not entered into a recession and usually the market tends to peak 7 months before we actually go into recession.
Lastly, investors also sort of shy away from the defensive groups, or advisors might not recommend them, because some people refer to defensives–meaning Utilities, Consumer Staples and Healthcare–as either cash or bond substitutes. Typically, equity-only mutual fund managers gravitate towards Consumer Staples and Healthcare if they are worried about the market and want to move into a cash-like equity environment. In terms of Utilities, well they’re really bond substitutes. They pay a very high dividend yield, 4.5 percent on average, and they also have the potential for dividend increases, capital gains, and so forth. So those are really favored by income-oriented investors, which are the older investors in general. So you have a greater number of cyclical sectors, you have a greater number of people who are gravitating toward cyclical sectors, and as a result, those are reasons why I think cyclical sectors are traditionally favored by Wall Street over the defensive ones.
