Standard & Poor’s Investment Policy Committee (IPC) voted on June 4 to reduce the year-end target for the S&P 500 to 1490 from 1560, citing increasing risks to a second-half recovery in equity prices.
Many of our positive forecasts for economic and fundamental share-price growth remain intact. In particular, it now appears as if gross domestic product (GDP) growth is likely to be positive in all four quarters of the year, rather than two negative quarters followed by two positive ones. We still see stronger GDP growth in the second half of the year compared with the first, aided by tax rebate expenditures and the effects of seven cuts to the Fed funds rate since September of last year.
S&P equity analysts continue to look for a second-half recovery in S&P 500 operating earnings in 2008. Even though projected first-half declines in year-over-year results for the S&P 500 consumer discretionary and financials sectors are expected to offset double-digit advances for six other sectors, we see positive second-half forecasts for all 10 sectors, and we think that will likely lead to an 8% advance in S&P 500 earnings for the full year.
In addition, valuations, both on a trailing and a projected basis, look relatively attractive, in our opinion. The P/E ratio of the S&P 500 at 1385 is 16.5 on a trailing 12-month basis. This represents a 15% discount to the average P/E of 19.3 since 1988, when S&P first started reporting S&P 500 operating earnings data.
Despite these restated positives, IPC members acknowledge an increase in risks to our economic and equity price forecasts. Since the beginning of the year, the price of West Texas Intermediate (WTI) oil rose nearly 50% through its late May high, while core inflation, as measured by the core CPI, continues to move further above the Fed’s comfort zone.
Earnings growth has also come under pressure in the past few months, as seen in the steady reduction of S&P equity analysts’ forecast for S&P 500 earnings growth in 2008 to 8% currently from around 16% at the beginning of the year. Full-year earnings estimates for eight of the 10 sectors in the S&P 500 have been reduced. Only the consumer staples and energy sectors have higher earnings estimates.
We made no change to our suggested asset allocation, which recommends a neutral exposure to U.S. equities (raised from negative on March 5, 2008), a neutral weighting of international stocks (lowered from positive on January 16, 2008), a negative weighting toward bonds (in place since November 2006), and a positive leaning toward cash.
We have a neutral investment outlook for U.S. equities, as we see the value of the S&P 500 rising 8.2% by year end from the 1377 level as of the June 3 close.
We also recommend a neutral exposure to international equities, as we believe they are not likely to maintain their multi-year outperformance in the near-to-intermediate term, given slowing global economic and earnings prospects. In addition, while the dollar remains relatively weak, we believe it may strengthen, or at least stabilize, in the second half of 2008, as overseas central banks begin to ease interest rates in order to offset slowing growth at home.
Finally, we continue to recommend underweighting bonds — and favor the shorter end of the maturity spectrum — as we see the yield on the 10-year note rising over the next year in anticipation of a rate-tightening program to be initiated by the Federal Reserve around mid-2009.