Wall Street strategists see U.S. stocks rising 12% next year, but most of the gains will come in the second half. Europe’s response to its problems will call the tune. The case for big dividend payers
For investors frightened by the stock market’s volatility in the past six months and tired of worrying about places in Europe once given little thought, 2012 promises scant comfort — at least in the first half. The outlook for the year ahead comes packaged with « if, then » caveats — as in, if the European Union implodes, then stocks will fall, possibly by a lot.
The mean prediction of the 10 stock-market strategists and investment managers surveyed by Barron’s is that the Standard & Poor’s 500 Index will end 2012 at about 1360, some 11.5% higher than Friday’s close of 1220. That sounds like a big gain, but a lot of things have to go right for the market to make such impressive headway. Even the most bullish of these Street seers fears stocks could be more wobbly in the next six months than in the six months past.
Ironically, 1360 is very nearly the same S&P 500 target offered up a year ago in these pages — for 2011. But what a difference a year makes. Last December, the strategists and investors we rounded up were looking ahead with modest but sturdy optimism. Investors can only look back with envy now to what seems a more hopeful, less dangerous time, when the main topic of debate was the sustainability of the U.S. economic recovery. By May the market had risen 8%, and seemed poised to motor to 1370 with ease.
BUT THEN S&P STRIPPED the U.S. of its prized triple-A debt rating. Congress barely reached an agreement to raise the nation’s debt-ceiling limit and keep the government running. And Europe pitched headlong into a sovereign-debt crisis that shows no sign of ending. Given today’s plethora of concerns, investors should derive some comfort from the fact that the S&P 500 is down only 3% for the year.
« One year ago we were in a much more positive spot, » says Barry Knapp, head of U.S. equity portfolio strategy at Barclays Capital. Knapp expects the S&P to end 2012 at 1330 but says the forecast is back-end loaded, and assumes « some degree » of stabilization in Europe and diminishing political uncertainty in the U.S. after the November 2012 elections.
Although many European banks have loaded up on the sovereign debt of nations that can’t repay it, even our most bearish prognosticators don’t expect the Continent’s financial problems to explode into a full-blown banking crisis on the order of 2008. Yet, the « nightmare scenario » must be considered. David Kostin, chief U.S. equity strategist at Goldman Sachs, says the S&P could fall to 900 — about a 25% drop from his 2012 target of 1250 — if multiple euro-zone nations defaulted on their debt. Conversely, an unexpectedly successful move to ameliorate the crisis could send the U.S. stock market sharply higher, to 1400.
INVESTORS WHO GET EUROPE RIGHT likely will do best in 2012. But other, domestic issues also will shape the market’s course. Chief among them are next November’s presidential and congressional elections, and all the commentary — about tax policy, entitlement spending, job growth and such — leading up to Election Day.
Then there are questions about the growth of U.S. corporate profits. The top-down call, or that of Wall Street’s market strategists, is that earnings per share will rise about 7% in 2012, to $105, for companies in the S&P 500, from this year’s estimated $98. The typically more optimistic bottom-up crowd of industry analysts calls for a 10% increase, to $108, although that forecast is down from an estimate of $113 in July. Analysts’ earnings estimates have been falling around the world, and both top-down and bottom-up projections for next year are lower than the 15% growth rate likely in 2011.
THE S&P 500 CURRENTLY TRADES at a price/earnings multiple of 12.5 times this year’s expected earnings. Given the uncertain political and economic backdrop, none of our bullish experts sees any meaningful P/E expansion until the clouds start to part toward the end of next year. In other words, the S&P’s advance to 1360, which is about 13 times the strategists’ 2012 profit forecast, will be supported by 5% to 7% earnings growth, and modest P/E expansion, at best.
Adam Parker, Morgan Stanley’s U.S. equity strategist, thinks the market’s P/E multiple could even drop in the next few years to as little as 10. He sees downside risk to Wall Street’s earnings estimates, and says « you pay a lower multiple for that. »
Still, U.S. stocks look cheap on a historical basis — especially when compared to U.S. Treasuries, says Tobias Levkovich, Citibank’s chief U.S. equity strategist. The spread between an 8% S&P 500 earnings yield — that’s the inverse of the P/E — and the 2% Treasury yield is near levels that in the past preceded big rallies for equities.
Bears say it is more likely the spread will be narrowed by a drop in Treasury prices than higher stock prices. But that is hard to imagine when the U.S. Federal Reserve has said it is committed to keeping interest rates low for a while.
IN ANY OTHER YEAR, these issues would provide more than enough for investors to cogitate on. But there are also concerns that Europe’s economy will slip into a recession, even if the Continent’s debt pressures ease, and that China’s economic engine will slow. The good news is, even the bears we polled don’t expect a recession in the U.S.
While American companies with substantial European business could be hurt, « the U.S. probably will prove reasonably resistant to a European recession if Germany doesn’t [contract] and the rest of the world is OK, » says Barclays’ Knapp. Barclays is projecting 2.5% growth in U.S. gross domestic product next year, up from an expected 1.8% this year. With regard to sectors, most strategists favor tech shares and recommend avoiding financials and raw-material stocks.
Few concern themselves with monetary policy, as it is unlikely to play a big role in shaping markets next year at home or abroad. There is a strong consensus that U.S. interest rates will stay where they are, and that rates will fall some in Europe and emerging markets, which would be a plus for stocks.
GIVEN THE CHALLENGES and the competition, the U.S. stock market just might be the best house on a bad block next year. It has been so this year, as the S&P 500, though relatively flat, has outperformed every other market index in dollar terms.
Money managers need equities to do significantly better in 2012, as most of the pros have underperformed for too long. Goldman’s Kostin notes that 84% of large-cap growth-fund managers were trailing their respective benchmarks this year, through Nov. 18. Most mutual-fund managers have underperformed year to date, following a similarly disappointing 2010, he adds. If 2012 turns out to be a third poor year of performance for portfolio managers, redemptions and pink slips might follow.
RETURNING TO THE INVESTMENT topic du jour, no 2012 market forecast can ignore Europe’s debt woes, even if it’s tempting to shut out the ’round-the-clock news of proposals put forth by EU leaders to keep the banks solvent, along with several small countries. At the least, says Robert Doll, chief equity strategist at BlackRock, « European leadership has begun to move to something that will be successful over time [in] combating the [debt] problem. The world isn’t going to end…we’ll muddle through. »
Haves and Have-Nots
Financials led the S&P 500 lower this year, with a big assist from raw-materials stocks. Dividend-paying utilities put in the best performance.
* Through 12/15.
Sources: Standard & Poor’s; Bloomberg
The strategists see a cumbersome and slow process of recovery, a two-steps-forward-one-step-back improvement in Europe’s outlook. While some expect some form of mutualization of debt across the euro zone, others think the European Central Bank eventually will buy the troubled bonds, despite its protestations to the contrary.
Federated Investors’ chief investment officer, Stephen Auth, calls the sovereign-debt negotiations « a slow-motion car accident, not a high-speed train wreck. » As such, he says, « politicians have time to work through the problem. » Moreover, the ECB has shown « it is focused on the banking system. » Bank-stock prices are one conduit of fear in the market.
Auth turned more bullish early this month, increasing the equities overweight in the firm’s model portfolio after a concerted intervention Nov. 30 to improve dollar liquidity at European banks.
INDEED, THE BERNANKE PUT, a reference to the Fed’s habit of pumping money into the financial system whenever crises occur, has morphed into the global central-bank put, says John Praveen, chief investment strategist at Prudential International Investments Advisors.
As in 2011, « stocks will struggle in 2012 mainly because Europe will continue to be a dark cloud, » Praveen says. « But U.S. markets should have modest gains. » Praveen is among the most bullish of Barron’s forecasters, with a 2012 year-end target of 1430. That is predicated, however, on the S&P 500 rallying to 1300 by the end of this year, which seems unlikely though not impossible.
To Praveen, the market’s currently low P/E multiple is pricing in extremely negative scenarios, such as a disorderly euro-zone default and the bankruptcy of some European banks. He expects debt-crisis fears to remain in early 2012, as a wave of sovereign-debt refinancings comes to market, testing the ability and resolve of euro-zone governments and the ECB to prevent defaults and defend the euro. As these fears subside, the market’s P/E is likely to move higher.
WHERE IN THE WORLD TO INVEST? That’s always a relevant question, but especially so with the U.S. stock market in the red this year and down 15% in the past five years. Parker, the Morgan Stanley strategist, recommends shares of companies with strong balance sheets; recurring revenue and relatively high dividend yields. A basket of such would include Philip Morris International (ticker: PM), which yields 4.1%, as well McDonald’s (MCD), Microsoft (MSFT) and Costco (COST), among others.
Even though cash-rich American companies have been raising their dividends, the S&P 500 dividend-payout ratio is at an all-time low, notes Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America Merrill Lynch. Subramanian favors stocks with sustainable and growing dividends, as well.
Thomas Lee, chief U.S. equity strategist at JPMorgan, is one of Wall Street’s biggest bulls. He expects corporate earnings to surprise on the upside « because expectations are so low. » Lee, who maintains a 2012 price target of 1430 for the index, notes that profits are healthy and companies are stepping up their share buybacks, which helps to lift stock prices. He predicts corporate profit margins will expand to 9.5% in 2012 from 9% this year, and to 10% or so in 2013. Europe, which accounts for only 8.5% of S&P 500 sales, concerns him less. Lee also expects the U.S. housing market to gain some traction next year, after four years in the dumps.
Lee’s main concession to bears is that European issues will make the first half volatile. But by the end of 2012 the Continent will be exiting from a recession, and there will be more clarity on the legislative front in the U.S., he says.
Goldman’s Kostin notes that since the spring, the market has favored stocks of companies that are domestically focused over those with sizable international sales. That’s quite a turnabout compared with recent years. Kostin expects the S&P to head to 1250 next year, and says stocks like Walgreen (WAG) offer the kind of high-quality earnings and dividend growth, plus domestic sales orientation, that will make for outperformance.
MERRILL’S SUBRAMANIAN THINKS the market’s recent preference for domestically oriented stocks is temporary, although it could continue for a while longer. Her domestic picks include Union Pacific (UNP), the railroad company; CenturyLink (CTL), a telecom-services provider; and Xcel Energy (XEL), the Minneapolis utility. CenturyLink yields a whopping 8.2%, and Xcel, 4%.
Subramanian favors technology stocks, even though many tech companies depend on government spending. But tech is the only cyclical sector in which earnings volatility has lessened, owing in part to lower leverage. Some 83% of tech stocks in the S&P 500 index are trading below their five-year average P/Es. Among her 10 stocks for 2012 is Apple (AAPL). She looks for the S&P 500 to rally to 1350 next year.
IT’S TOO SOON TO HANDICAP November’s elections, although the market might prefer a Republican in the White House. History suggests, however, that there is no relationship between investment returns and the party of the president in the four years of a presidential term. In fact, stocks have done better under Democratic presidents, Subramanian notes, while bonds have done better when the Grand Old Party is running the show. « It’s a trading call, » she says.
In recent years past, investors’ interest in the U.S. and Europe sometimes took a back seat to their enthusiasm for emerging markets. Next year could be one of slower growth in developing markets, and some experts are concerned about China’s ability to sustain its current growth rate approaching 10%. Interest-rate cuts in China and Brazil are positive moves, however, and could continue to support local economies and stock prices.
NEXT YEAR COULD BE the year when investors rediscover the appetite for risk, says Jeffrey Knight, head of global asset allocation for Putnam Investments. Knight, who calls himself « fairly optimistic, » says, « We won’t outrun the secular issues that won’t be fixed anytime soon. But there could be a recognition that a modicum of profit growth is possible as we work through these issues, and if governments prudently address them. »
As all market forecasters know, surprises can overturn even the most elegant assumptions. And there is no lack of things that could surprise next year. Tensions could flare in the Middle East, which would affect oil prices, for instance. Perhaps the worst risk, says Putnam’s Knight, is that European leaders « lose control and get a cascading banking crisis that hits the rest of the world. »
Good surprises can happen, too. If Europe gets on firmer footing, a « catch up » trade could ensue as investors acknowledge this year’s earnings growth and the possibility of a stronger economy next year. And if the U.S. housing market finally finds a bottom and becomes a net contributor to GDP, that would also be an enormous plus.
Finally, any rearrangement of the power players in Washington that « facilitates improved deficit and debt policy, » as Barclays’ Knapp puts it, would be encouraging for investors. But that, like so much else next year, would be a second-half event.
Only one thing seems certain about 2012: It won’t be dull.