Secular Bull Update: Remember, buy on dips
Not to beat a dead horse, but it’s worth reiterating that long-term investors should be equity buyers on dips. This comes amid this week’s minor pullback in stocks, fueled by another round of tapering talk. The reality is Fed Chairman Ben Bernanke appears fully committed to beginning easing off the throttle in September; the only undecided item is how much will he pare the $85 billion in monthly government and agency debt security purchases—the “dial” that Fed governors such as New York’s William Dudley have often spoken about. We think Bernanke was thinking in the range of $40 billion back in June and may now be thinking $10 billion to $20 billion. But some amount almost assuredly will be done next month.
As long as this tapering comes with the growth acceleration we’re expecting, our secular bull thesis and 2,000 target on the S&P 500 for 2014 remains intact. For the last four years, a key bull-market driver has been the declining expectations that another 2008 could happen at any minute. In recent discussions with clients and most of Wall Street, we’ve been struck by how little pushback we are now getting on our argument that the world is unlikely to end soon. It’s as if a collective light bulb has gone off this summer, and I think that is going to drive a lot of pent-up demand. Household and corporate balance sheets are in the best shape they’ve been in a decade, so the capacity is there; we just need the will.
Even with very little revenue growth, valuations on the S&P have been able to rise from 11 times forward earnings at the lows to 15.5 times now. This is typical of the first leg up of a bull market: things don’t get better, they just don’t get worse. Now we are shifting to the second phase, stronger growth. We expect real GDP to grow above 3% in the fourth quarter and to accelerate further to 3.5% to 4% in 2014. With most U.S. companies planning for far worse, and hunkered down accordingly, the top-line surprises will drive through to earnings, giving us an explosion to the upside. The just-completed earnings season, for example, already saw improved revenue guidance, and we think S&P earnings could be $120 next year. That would help push the market multiple to maybe 17 times, getting us north of 2,000 on the S&P.
Driving growth, as noted before, will be the release of pent-up demand for both consumption and capital investment, led by the continued recovery in housing. With prices rising again, inventories depleted and household formation expanding above trend as Johnny and Mary move back out of Mom’s house, housing starts are slated to potentially double again over the next two to three years. Non-residential construction should follow. Construction historically has been 9% of GDP and is currently flat at 5%—it’s where all the missing middle-class jobs are, and the spending multipliers here are high. The energy build-out also should accelerate, with shale-extraction technologies we are applying in the center of the country poised to take us from a net importer to a net exporter of oil within 10 years. This is big not only for the economic activity it creates but also for its derivative impact on the competitiveness/growth of domestic U.S. manufacturing. (The Obama administration’s green coalition may or may not like this, but they are struggling to stop it. When they clamped down on the pipelines, for example, enterprising oilmen shifted to train transport, which is now growing in favor because sellers can better link specific oil grades with specific refinery needs. It’s hard to stop progress.)
Other factors that should abet—or at least not impair—growth include the winding down of the government’s downsizing. The public sector has been a big drag on economic activity as it has gradually right-sized itself vis-a-vis the private sector. Although this retrenchment process is not over, it should decelerate, particularly at the federal level where fiscal imbalances are starting to correct—the budget deficit relative to GDP is expected to fall to about 2.5% of GDP in the coming fiscal year, down from 10% just five years ago. We don’t expect or want government to contribute to growth, but if just gets less worse, that will allow the underlying growth in the private economy to shine through. The trade picture also is improving. Our export sector has been slowed simply because the overseas economies of Europe have been in recession and the emerging economies have been slowing. This is changing. Numbers out of Europe of late suggest stabilization and even growth, while Japan’s revival appears for real. The emerging economies’ slowdown also seems to be ending—this week, China reported that exports rose more than 5% year-over-year in July and imports jumped nearly 11%, both big upside surprises.
Where we stand
Given this back drop, our asset-allocation models are recommending long-term investors to:
- Be overweight equities. Equities are in a bull market and should be bought on dips. Bonds, on the other hand, are clearly in a bear market. With all due respect to Pimco’s Bill Gross, who likened bond’s recent sell-off and situation to World War I’s Battle of Somme, where more than a million people were killed over five months, I’d rather retreat to higher ground then hang around to see who wins. If you must own bonds, we certainly believe you should be holding credit, i.e., investment-grade and high-yield corporate bonds, and emerging-market bonds to protect yourself somewhat from rising interest-rate risk.
- Use dividend-producing stocks to replace the bond income. These stocks won’t likely outperform the broader market but they’ll likely outperform most bonds. For instance, during the “Taper Tantrum” of late June/early July, dividend stocks held flat even as representative aggregate bond indices declined.
- Consider cyclical stock sectors with the most operating leverage to an upside GDP surprise. This recommendation is geared toward total-return investors. We like consumer discretionary/housing related, industrial, technology and financial sectors. We think the outperformance we’ve seen over the last few months has a long way to go.
- Favor U.S. over international but watch for emerging value in several emerging markets. Investors with patience and higher risk appetites may want to consider South Korea, Brazil and Indonesia. Among the larger markets, we like Germany (levered to the global upturn) and Japan (Abenomics looks to be both sustainable and effective.)