Wall Street strategists who correctly called the stock market's recovery this year expect continued low rates and rising profits to drive up share prices again
By Lynn Thomasson
(Bloomberg) — The Wall Street strategists who correctly predicted U.S. stocks would rebound from the steepest plunge since the Great Depression now say the Standard & Poor's 500 Index will rally 11 percent next year.
Thomas Lee, the chief U.S. equity strategist at JPMorgan Chase & Co., and Goldman Sachs Group Inc.'s David Kostin, this year's most-accurate forecasters, say Federal Reserve interest rates near zero and profit growth of more than 26 percent will drive the S&P 500 to 1,300 and 1,250, respectively, in 2010. The combination of higher earnings and an increase in mergers and acquisitions will boost the index to 1,250, according to Thomas Doerflinger, a senior strategist at UBS AG in New York.
While analysts failed to foresee 2008's crash, when credit markets froze and the S&P 500 fell the most since 1937, investors who followed their advice this year were rewarded with 22 percent gains. The index will end 2010 at 1,223, according to the average of 10 projections in a Bloomberg News survey. Their optimism clashes with Pacific Investment Management Co.'s Mohamed El-Erian and economist Nouriel Roubini, who predict smaller returns or losses.
"It's hard to imagine that the optimistic scenario is baked into stocks," Lee said. "Everyone is going to fight the recovery. It's the error of deep pessimism."
The S&P 500 rebounded 64 percent from a 12-year low in March after manufacturing and consumer spending increased and the U.S. government lent, spent or guaranteed more than $11 trillion to end the recession. The index rose less than 0.1 percent last week and ended at 1,106.41. March futures on the gauge rose 0.5 percent to 1,108.50 at 7:38 a.m. in New York.
Sticking to Forecasts
It didn't look like strategists would be right as 2009 began and the S&P 500 sank to 676.53 on March 9, falling 25 percent in its worst start on record. They stuck to their forecasts, predicting a 43 percent surge to 966 through Dec. 31, which would amount to a full-year 2009 gain of 6.9 percent.
"We were perceived by many of our clients in March and April as literally lunatics," Tobias Levkovich, New York-based Citigroup's (C) top U.S. equity strategist, said in a Dec. 11 interview. His prediction for 1,000 on the S&P 500 has proved too conservative.
"Last week, I had dinner with a guy who had called me a lunatic, who didn't really buy," Levkovich said. "And he said, 'I should have listened.'"
Combined earnings for S&P 500 companies will jump 23 percent to $73.69 a share next year from $59.82 in 2009, according to the average of strategist estimates compiled by Bloomberg News. Economists say U.S. gross domestic product will rise 2.6 percent in 2010 after shrinking 2.5 percent this year, according to the median forecasts.
JPMorgan's Lee, who projects that S&P 500 profits will reach $80 a share next year, says investors should buy shares of companies that can increase earnings the fastest, such as technology and material stocks. Lee, in New York, sees the S&P 500 rising 17 percent to 1,300 through Dec. 31, 2010.
Goldman Sachs (GS), the most profitable investment bank, says the Fed's target rate for overnight loans between banks won't rise until at least 2012, according to a Dec. 7 note. Fed funds futures give 60 percent odds that the central bank will raise interest rates by August, compared with 46 percent in June, Bloomberg data show.
New York-based Kostin, who wasn't available for an interview, has a year-end 2010 forecast of 1,250.
Cheap Bank Shares
Binky Chadha, Deutsche Bank AG's chief U.S. equity strategist in New York, predicts the index will climb 14 percent to 1,260 and is most bullish on financial companies because the economy is improving and the shares are inexpensive. A measure of banks, brokerages and insurance companies in the S&P 500 trades for 1.1 times book value, or just above the net cost of assets. That's 48 percent less than the average in Bloomberg data going back to 1993.
"Equities remain very cheap," Chadha said in a Dec. 11 interview. "The market isn't discounting the recovery yet. It's going to be gradual, but a recovery nonetheless and that will give you earnings growth."
Even if the S&P 500 meets the average strategist forecast, it will still need to advance another 28 percent to reach the October 2007 record of 1,565.15. The index plunged 57 percent following that peak through March amid subprime mortgage-related losses at banks that now total $1.71 trillion and the credit crisis that followed the September 2008 collapse of New York- based Lehman Brothers Holdings Inc.
Strategists are estimating smaller gains after the nine- month rally that was the steepest since the 1930s. The median annual increase by the index since 1927 is 9.1 percent, according to data compiled by Bloomberg.
"They've sobered up," said John Lynch, chief market analyst at Evergreen Investments, which managed $155.5 billion as of Sept. 30 in Charlotte, North Carolina. "The market can still go higher than where we are today, but we have to be prepared to slip and slide."
To El-Erian, Pimco's chief executive officer, and Roubini, the New York University professor who predicted the global financial crisis, the strategists are too optimistic.
Pimco says investors should expect returns that trail the historical average because of heightened government regulation, lower consumption and a smaller role for the U.S. in the global economy. Stocks will fall 10 percent or more next year as economic growth remains weak, El-Erian said in a Dec. 10 interview with Bloomberg News.
"Liquidity had completely overwhelmed the fundamentals," he said in an interview from Newport Beach, California. "Now we're starting to see some breaks. We're starting to see some discrimination."
Surging global equities and commodities mark the beginning of a bubble in financial markets, according to Roubini, who is based in New York. The "vulnerabilities and imbalances" that created the credit crisis have yet to be resolved, he wrote in a Dec. 2 post on his Web site. Roubini didn't return requests for comment.
The most newsletter writers in 17 years are predicting a correction in U.S. stocks — generally considered a 10 percent decline — data from Investors Intelligence showed last week. Advisers expecting a correction increased to 35.1 percent from 33.3 percent, the survey of about 140 newsletters by the New Rochelle, New York-based research firm showed. The last time the level was that high, the S&P 500 slid 3.1 percent in the following month.
Equity derivatives also indicate concern stocks will slip. S&P 500 options to protect against losses in 2010 are 33 percent more expensive than one-month contracts, among the highest premiums in the past five years, according to data compiled by Bloomberg.
Strategist estimates have missed the S&P 500's swing each year by a median 8.5 percentage points in the decade Bloomberg has tracked the data. The prediction for a 3 percent advance in 2005 was the most accurate on record as the S&P 500 matched the gain, Bloomberg data show.
Investors who followed Wall Street's advice in 2008 lost money as the first global recession since World War II erased as much as $37 trillion from global equity markets. The S&P 500 was forecast to end last year at 1,632, according to the average projection. It sank to 903.25 through Dec. 31, or 45 percent below the estimate.
The least accurate 2009 projection was from Barry Knapp at London-based Barclays (BCS), who said in January that the S&P 500 would end the year at 874, or 21 percent below its current level. The New York-based forecaster said he failed to anticipate the extent of the Fed's programs to reduce borrowing costs and ease the financial crisis.
"We underestimated the magnitude of the rebound," Knapp said in a Dec. 10 interview. "The Fed was just so aggressive this year. I think that's the main reason we were off."
Knapp projects the S&P 500 will fall to 990, an 11 percent drop, during the first half of 2010 as the Fed withdraws stimulus from the economy, before rebounding to end the year at 1,120. The central bank began testing a tool for draining money this month while stressing that the trials themselves don't represent a change in policy.
Levkovich at Citigroup, which the U.S. government bailed out last year, is the least bullish of the strategists after Barclays's Knapp and Andrew Garthwaite of Zurich-based Credit Suisse Group AG, with an S&P 500 forecast of 1,150 for next year. That's 3.9 percent above the index's last close.
He says the rally may stall next year as companies struggle to meet forecasts for earnings growth. Companies in the S&P 500 are estimated to increase profits by 52 percent to $95.49 a share by 2011, based on projections from company analysts tracked by Bloomberg.
"As earnings beat expectations early in the year, analysts will ratchet up the numbers and create a higher hurdle rate that companies can't quite get over," Levkovich said in a Dec. 11 interview from New York.
UBS's (UBS) Doerflinger is less pessimistic, in part because of the prospect for takeovers. Companies outside the financial industry in the S&P 500 are holding 9.7 percent of cash as a percentage of assets, a record, according to data from Goldman Sachs.
The value of announced mergers fell 46 percent in the U.S. from last year's total to $456.2 billion in 2009, which would be the lowest full-year amount since 2003, Bloomberg data show.
"We are in a stage in the recovery where growth has to come in and deliver," said Jeffrey Palma, the head of global equity strategy for Zurich-based UBS. "We're expecting the economic recovery to continue in 2010 and with it strong earnings growth, creating a supportive environment for equity markets on a global basis."