Don’s Outlook 7/9/2010
Investors have clearly become more sensitive to the possibility that economic growth can slow and that earnings growth over the next 12 months could be less than projected. However, few economists at this point are willing to refute that a global economic recovery is still underway and that many corporations remain in strong financial health with solid balance sheets. Yet it took the market reaching deeply oversold levels before investors swooped in to buy up even the most beaten down stocks and sectors this week. The S&P 500 Index climbed more than 4.5 percent in the holiday-shortened week before taking a breather on Friday.
Weaker-than-expected data points in the months of May and June mean that the U.S. economy is likely to grow at a slightly slower 3.0 percent annualized pace for 2010 and remain at that rate for 2011. Economists are not prepared to make drastic cuts in their projections due to several factors. Despite some poor headline results, there have been signs of labor improvements among the private sector, such as rising payrolls and a pickup in quarterly average income growth. The Conference Board Employment Trends Index, which takes into account eight labor-market indicators, was up 0.6 percent in June, the eleventh consecutive increase. More important, the fact that the Federal Reserve is keeping interest rates at such low levels well beyond expectations means that credit and housing markets will receive support even longer than was projected.
As I mentioned last week, there is a great divergence between the long-term valuation of government bonds and the S&P 500 Index. According to Bianco Research, this disparity has now reached historic levels. Stocks have underperformed long-term Treasury bonds over a rolling 20-year period, something that has happened only twice in the past 140 years. While this would appear to turn on its head the widely held theory that stocks always outperform bonds in the long run, there is bound to be a reversion in the making. Although there remains a risk of economic stagnation ahead, the great bull market in bonds is long in the tooth at more than 28 years.
Moreover, at multiples of 10 times estimated 2011 profits, it is rare to find stocks this cheaply valued when earnings estimates remain as robust as they are. We must contrast this environment with the one prevailing in late-2002 or early-2009, when the economic picture may have been murkier or the financial crisis was still unfolding. But given current multiples and the sudden preponderance of bears reported by investor surveys and the media, there is clearly a growing skepticism over analysts’ forecasts. Yet with the S&P 500 yielding 8 percent and the 10-year note yielding 3 percent, the gap is as wide as it has been since the late 1970s. Typically this bodes well for future S&P 500 returns, but we may need a little more economic proof before we are in the clear.
