As Sam Sees It: Where Will Stocks Go After Hitting New Highs in Q1?

Sam Stovall |

Sam Stovall Chief Equity Strategist for S&P Capital IQEach week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.

EQ: The first quarter of 2013 wrapped up in a very nice way, culminating in the S&P 500 finally breaking through to a new record close. What were your thoughts on the market’s performance in the first quarter?

Stovall: I was very impressed. The S&P 500 was up 10 percent for the first quarter with all 10 sectors in positive territory. The market also closed higher in each of the three months, and I thought consistent growth all the way across was a fairly positive sign. I decided to analyze whether that is a good indication for the rest of the year, or an implication that the market was going to tire because we went out of the gate so quickly. I was pleased to find that history says, but does not guarantee, that a favorable first quarter actually serves as a running start for the rest of the year.

Since World War II, whenever the first quarter was positive, instead of getting the normal 6-percent price appreciation for the rest of the year, you ended up getting an average of 9-percent price appreciation for the final three quarters. In addition, I found that the three best-performing sectors in the first quarter tended to do better too when the market itself is higher in the first quarter. Not only did they experience a higher price appreciation than normal, averaging 12 percent from the normal 8.5 percent, but both the market as a whole and the top three sectors in particular all saw an increase in the frequency of advance. In other words, their batting averages also improved. That implies that because of that running start, there is a greater likelihood the market itself will be up in nine months, and the top sectors in the first three months of the year will continue as a whole to outperform the market in the remaining nine months of the year.

EQ: In our previous interviews, you said that you were expecting a possible 2 to 3 percent move above the new high before eventually experiencing a pullback. We haven’t seen stocks make that move higher yet. Does that concern you at all?

Stovall: It is sort of interesting that the market is giving back some of these gains early on. We peaked above the all-time high of 1565, but we really didn’t go much higher before dipping below that level. So what I do think is important is how the market performs in the next couple of months after reaching an all-time high. Normally, we have to advance 3 percent or so over two months before stumbling from exhaustion. But nothing is guaranteed in this business, and I think what’s really causing investors to worry are the continued signs of economic weakness in Europe, and the less-than-stellar economic numbers coming out of the U.S., which could end up overruling the slowdown that continues in Europe.

EQ: As you noted in this week’s Sector Watch, the move higher was driven largely by the defensive sectors. How much of this has to do with the Fed’s stimulus programs? How much of it is attributed to investors deciding to dip their toes into the market through more conservative areas?

Stovall: I think both reasons are viable as to why the market is doing well. I think investors who had been out of this bull market since it began four years ago are now joining this rally reluctantly. So rather than jump into the more cyclical sectors, which typically do well from November through April, they’re going to gravitate instantly toward the defensive sectors. The thinking is that if they are joining the party just at the wrong time, they would rather be in those groups that traditionally fall less during market declines. Also, these happen to be the sectors that offer relatively nice dividend yields. The five defensive sectors—Consumer Staples, Energy, Healthcare, Telecom, and Utilities—offer an average dividend yield of 3 percent, versus an average dividend yield of only 2 percent for the five other more cyclical sectors. In a sense, they serve as bond substitutes. I think these higher-yielding sectors have become attractive to investors who don’t want to buy bonds now for fear of higher rates, and if they’re going to buy stocks, they’re going to go for the low-beta and high-yielding issues.

EQ: Last week, the SIPC raised its 12-month target for the S&P 500 to 1,670. What will be some of the drivers for that move higher?

Stovall: S&P Capital IQ’s Investment Policy Committee raised our target because we think 12 months from now, we will be seeing earnings close to $112 for the S&P 500, and because we expect the economy to be a bit stronger a year from now than it is today. Also, we could probably experience some P/E expansion, up from the current 14 times projected earnings to 15 times a year from now. The average since the secular bear market started in 2000 has been 16 times next 12 months earnings. Our belief is that even though we will still be below that level, we won’t need to be so depressed as to remain at 14, but could see investors gain a little bit more confidence to be willing to move up to the 15 level. From there, we will re-evaluate if need be should investors regain their confidence.

EQ: What are some headwinds that investors face in the coming quarters as volatility is expected to increase?

Stovall: We’re heading into the first quarter earnings reporting season, and many people are worried that right now, Wall Street consensus estimates point to a gain of about 0.5 percent as compared with the near 8 percent gain that we saw in the fourth quarter. Some investors may be worried that perhaps the trough quarter in earnings was not the second quarter of 2012, and that actually, we could be experiencing more weakness in the quarter to come. Others believe, however, that now the bar is set so low, and because companies have had such a track record of managing expectations, that once again quarterly earnings will likely beat Wall Street estimates.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. 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: http://www.equities.com/disclaimer

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