Jim O'Neill, the chairman of Goldman Sachs Asset Management and the man who coined the term BRICs, says this is "the year of the U.S. comeback." Meanwhile, Bob Doll, chief equity strategist for fundamental equities at BlackRock, says we should expect "a nice surprise" from U.S. equities. Is it time to put your inner bear back in its cage and make a big bet on U.S stocks?
An accelerating recovery
If you've been following my articles, you know I've been pretty bearish with regard to the U.S. economy and stocks through the rally that began in April 2009 (with the exception of the high-quality segment of the market). However, when the facts change, I'm forced to change my mind.
While the recovery has been weak by historical standards, the signs now suggest that it is gaining steam. As recently as the start of the year, I told a Foolish colleague that I thought the economy would grow no faster than 1%-2% this year. That now looks excessively pessimistic, and I'm happy to throw in with the consensus range of roughly 3%-4%.
Impressive earnings surprises!
For months, I considered the estimates for S&P 500 earnings for 2010 and 2011 were a cruel siren song, luring investors toward the shoals of illusory stock market profits. However, the 2010 estimate was no mirage, since the S&P 500 delivered on analysts' promise -- and more:
S&P 500: Bottom-Up Operating Earnings Per Share
|Estimate, at October 2008||$103||--||--|
|Estimate, at November 2009||--||$75||--|
|Surprise||Hugely negative: (45%)||Positive: +12%||?|
Source: Capital IQ, a division of Standard & Poor's. *With 54% of companies having reported for the fourth quarter of 2010.
I still have concerns about the level of profit margins, but not as much as I did. The odds look pretty decent that 2011 will be the first post-crisis year in which earnings exceed the previous high set in 2006 (the figure $87.72; the growth trend continued midway into 2007, with trailing-12-month earnings to June 2007 of $91.47). Is that enough reason to buy stocks?
Better growth outlook -- does it matter?
Even if we assume the S&P 500 achieves those profits, it's far from clear that companies will be able to sustain earnings growth at historical rates from that level. While stocks may appear cheap on a multiple of estimated 2011 earnings, they look markedly expensive once earnings are normalized to account for the business cycle. The cyclically adjusted P/E multiple (or Shiller P/E), which is based on average inflation-adjusted earnings over the prior 10 years, is now roughly 43% above its long-term average.
High quality ... still
In that context, if you're a talented speculator or stock picker or you own funds that are managed by people who fall into either category, it may be entirely defensible to be overweight in stocks at this time. For reference, fund manager GMO had a 25% weighting in U.S. equities in its Global Balanced Asset Allocation strategy at the end of September -- 25% of which it designates as "quality." The list of top holdings reveals multiple household names:
Forward P/E (NTM earnings)
|Apple (Nasdaq: AAPL )||14.2||32.9|
|ExxonMobil (NYSE: XOM )||11.5||10.1|
|Johnson & Johnson (NYSE: JNJ )||12.3||14.9|
|Oracle (Nasdaq: ORCL )||14.9||27.4|
|Pfizer (NYSE: PFE )||8.3||10.6|
|Procter & Gamble (NYSE: PG )||15.3||19.0|
|Microsoft (Nasdaq: MSFT )||10.6||15.2|
Source: Capital IQ, a division of Standard & Poor's, and author's calculations.
It should be clear to investors that the high-quality segment, which usually commands a premium to the market, is relatively undervalued right now (manifestly, it isn't all that clear since the phenomenon has shown extraordinary resilience). Note, for example, that all but Oracle and Apple trade at a discount to the overall market on the basis of the Shiller P/E. Even in the case of the two technology giants, a premium multiple is not proof of overvaluation; indeed, as I've noted in the past, the Shiller P/E is biased against legitimate high-growth companies.
On an absolute basis, large-cap quality stocks still look like an acceptable proposition as a group, and some individual names are even better than that.
Cash as an alternative
Looking for other ideas? How about cash? Ben Inker, the head of asset allocation at GMO, recently told Barron's, "Right now our cash position is about 30%." With a correction in U.S. equity markets long overdue, raising cash doesn't seem like a wild idea right now. No one wants to touch the stuff when they're watching stock indexes levitate ever higher, but as this month's events in North Africa demonstrate, no one can forecast the catalyst that will raise investors' risk aversion. In an overheated market, having access to liquidity can put you in a very powerful, very profitable position once that surprise catalyst comes knocking.
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