Is the U.S. Ready to Surprise Again?

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 --
Current estimate -- -- $96
Actual $57 $84* ?
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)

Shiller P/E

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
S&P 500 13.3 23.4

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.

One sector -- energy -- is benefiting from a massive economic tailwind, and The Motley Fool has identified the The Only Energy Stock You'll Ever Need.

Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. Johnson & Johnson, Microsoft, and Pfizer are Motley Fool Inside Value recommendations. Apple is a Motley Fool Stock Advisor choice. Johnson & Johnson and Procter & Gamble are Motley Fool Income Investor selections. The Fool has written puts on Apple. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Apple, ExxonMobil, Johnson & Johnson, Microsoft, and Oracle. Motley Fool Alpha owns shares of Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (13) | Recommend This Article (42)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 31, 2011, at 5:04 PM, fire56 wrote:

    Nothing new here, buy the recommendations,put money in their pockets. You gotta have inside tips

    that you won't ever get.It's a "fools game"....

  • Report this Comment On January 31, 2011, at 5:16 PM, xetn wrote:

    Don't confuse inflated prices for economic growth.

  • Report this Comment On January 31, 2011, at 5:55 PM, mtracy9 wrote:

    These "analysts" are always late to

    the party. They should have gotten

    of board 2 years ago when the Dow

    was at 8000. As Buffett said, "By the

    time things become clear, its too late."

  • Report this Comment On January 31, 2011, at 6:00 PM, TMFAleph1 wrote:

    I remember fondly a pre-Internet era when it was still possible to obtain constructive criticism...

    Alex Dumortier

  • Report this Comment On January 31, 2011, at 6:19 PM, TMFAleph1 wrote:


    A conspiracy theorist on the Internet? Nothing new there, I'm afraid. ;-)

    Alex Dumortier

  • Report this Comment On January 31, 2011, at 6:31 PM, TMFAleph1 wrote:


    I don't follow you: What inflated prices are you referring to and how am I confusing them with growth?

    Alex Dumortier

  • Report this Comment On January 31, 2011, at 6:39 PM, MartinSamuelson wrote:

    Oh baby stocks are going to boom big-time for the next few years at least. I'm all in, every last penny I can scrounge up. Blue chip dividend payers are cheap, mobile computing and cloud computing growth stocks are going to be the monsters of the coming decade.. It's game on!

  • Report this Comment On January 31, 2011, at 6:47 PM, Merton123 wrote:

    I wish that an additional column could have been added for trailing P/E ratios in the above article. Mondays (Jan 31st edition) Wall Street Journal had two articles - one about the S&P 500 being able to soundly beat analysts expectations for earnings growth, and the other about inflation rearing its ugly head in the emerging markets. When the Chinese start raising interest rates the stratospheric P/E ratios may deflate providing some great buying opportunities. The Feds in the US may also start applying the brakes so cash may be the best option. I suggest dollar cost averaging into Vanguard Total Global Index or putting your money into Motley Fool Independence Fund and focus your attention on the Super Bowl and let other people worry about the market :)

  • Report this Comment On February 01, 2011, at 1:54 AM, SaintAndrew wrote:

    I agree somewhat with Merton123. Business Professor Michael Pettis (who's a former investment banker from the days of the LatAm crisis and specializes in Chinese issues these days -- ) speculated that from a macro perspective the US stock market would likely boom in the near term while the Chinese and other emerging markets had foreign exchange surplus that they needed to recycle to keep their currencies undervalued. I'm not the type to trade specific issues on macro trends, but it is a good idea to keep an eye on the tide that's underneath the trend likely floating a lot of boats in the market these days. Even Pettis mentioned this would likely be a near term phenom and a final rebalancing reckoning needed to reached eventually. Looks like emerging market inflation (and unrest) is going to be part of that reckoning, we'll have to see if a US market pull back (or long period of sideways movement) is another part when this source of cheap funding is removed and the recovery impetus gets long in the tooth. As Alex mentioned, the P/Es are a bit steep to justify the continued rise, they're being priced so all that would justify them is a continued "perfect" outcome/recovery for the next several years. While this is a market recovery from a downturn the likes we haven't seen in living history and thus likely to be big (and I'd argue it already has been), I wonder just how likely is it to continue to outperform versus drop to a tepid reality?

  • Report this Comment On February 01, 2011, at 2:13 AM, SaintAndrew wrote:

    Cite to another macro article backing up some of what I mentioned -- Tim Duy's FedWatch

  • Report this Comment On February 01, 2011, at 11:19 AM, jrod87 wrote:

    lol the wall street casino and its players and its employess. wow gotta love it. at least at the casino i get free beer! fyi i love to pump and dump long and short term makes no diffrence to me. i suspect the "fools" are the same in thinking even if "they" dont say it out loud.

  • Report this Comment On February 04, 2011, at 7:14 PM, LAVol wrote:

    "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."

    Geez! If this guy is getting bullish, then I think I might turn bearish. I had 100% returns in 2009 and 30% in 2010, up 7% so far in 2011. Buy low, sell high. Buy when everyone else is selling, sell when everyone else is buying. Best advice I've ever had.

  • Report this Comment On February 05, 2011, at 3:38 PM, Merton123 wrote:

    I would like to make an argument that the S&P 500 index is not overvalued. The companies in the S&P 500 (e.g., Yum) are investing in the emerging markets (building thousands of Kentucky Fried Chickens Stores in Yums case). Eventually these investments are going to start generating additional earnings. The ultimate driver for the Stock Market is earning growth - or to put it differently being able to sell goods and services to more people. We have a large group of people (Africa, Asia, Eastern Europe) who are becominging economically mainstreamed. This is what will be driving stock market prices up for the next century. After that all the current readers of Motley Fool will be buried and the next generation of investors will have to worry about where earnings growth will come when everybody is economically middle class

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