Equity Outlook: Growth set to star in secular bull's second act

07-01-2013

It could be the 6% correction in the S&P 500 from late May through late June is it, but we wouldn’t be surprised—or worried—if there’s a little more to come. Even before the events of the past month, driven largely by somewhat countervailing messages from Federal Reserve policymakers in regards to the timing of a potential tapering of quantitative easing, we had felt stocks were getting ahead of themselves and were due for a healthy consolidation. Once this cleansing passes, we believe the stage will be set for another run to—and likely past—our year-end target of 1,660 on the S&P. More significantly, we are establishing a 2,000 target for 2014 as this secular bull shifts from “you mean the world is not ending?” phase to “you mean we're growing again?” phase.

Some key points to consider:

  • Healthy consolidation The S&P run through mid-May of this year was almost straight up, as too many investors were positioned for the world to end soon and it didn't, forcing the doubting Thomases to cover shorts and adding to the market’s fundamental upward momentum. Key milestones have been events such as Cyprus, hailed as "Europe's Lehman Moment" which it wasn’t—potentially the final straw for "the sky is falling" seers; the Bank of Japan joining the global central-bank liquidity party; the definitive turnaround in the housing market, which was supposed to be permanently dead; and the confident crack through the double top on the S&P, which was supposed to be the ceiling on the "bear market rally" off the 2009 lows. We think we're in the midst, if not near the end, of a 5 to 7% correction that will wash out some of the "bears in bull clothing."
  • A new market driver Importantly, we think cyclicals are replacing defensives as the driver of this bull. The first phase was a revaluation of equities to a more fair multiple (currently, almost 15 times forward earnings) as investors gradually realized that the world is not ending (our key theme the last four years).This phase was marked by particularly strong performance of more defensive, dividend-yielding stocks in the consumer staples, telecom and utilities sectors, and of course, in bonds. We believe this phase has now ended. From mid-April, investors began to wonder if real economic growth might actually return, and began to focus on the timing of the Fed’s eventual tapering of QE. Since then, bonds, utilities and telecom have declined, and cyclical sectors such as banks, tech, and industrials have risen, a rotation our equity team was calling for in early spring.
  • GDPs higher gear We expect U.S. growth to stun people to the upside later this year and next, with real annualized GDP in the 3% to 4% range. We see a number of catalysts behind this shift to a higher growth gear: Accelerating  strength in housing, a lagged pickup in non-residential construction, multiplier effects of spending by workers in construction sector, continued growth in domestic energy and manufacturing sectors aided by robust auto sales and all that’s related to that, a slowdown in government cutbacks as tax receipts grow and repair fiscal stresses, and reacceleration in international economies, including Japan, South Korea, and Brazil. As long as the Fed begins tapering in the face of renewed growth, the markets should move higher.
  • Risk in Treasuries With the Fed on the verge of tapering, we think there are continued risks in the Treasury market. Assuming inflation eventually gets closer to the Fed’s 2% target, and assuming a more normal risk premium on 10-year government bonds of 2.5%, it is reasonable to imagine the 10-year U.S. government bond’s yield reaching 4% to 5% over the next three years. We think equities can handle this move upwards as long as the economy is strong (which by definition of the Fed’s tapering policy, it would have to be), and as long as the move up is gradual, not sudden. In this regard, it was encouraging to see the 10-year settle down this week after the initial shocked move higher last week. For the near term, we expect the yield to remain below 3% until move evidence of the economic strength we expect in 2014 begins to emerge.

What should investors do?
Our investment research team is recommending an overweight to domestic equities and to cyclical growth sectors (finance, technology, industrials, consumer discretionary) and an underweight to the aforementioned defensive sectors. We don’t like bonds, particularly Treasuries. Outside of the U.S., we also like the equity markets in Germany, South Korea and Japan.

Stephen F. Auth
Stephen F. Auth, CFA
Chief Investment Officer, Equities, overseeing all of Federated's equity and asset allocation products globally


 
 
 
 
 
 
 
 
 
 
 
Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.
Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.
Diversification and asset allocation do not assure a profit nor protect against loss.
Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.
International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Prices of emerging-markets securities can be significantly more volatile than the prices of securities in developed countries, and currency risk and political risks are accentuated in emerging markets.
Price-earnings multiples (P/E) reflect the ratio of stock prices to per-share common earnings. The lower the number, the lower the price of stocks relative to earnings.
S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.
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