Equity Outlook Brightens

The end of the Fed’s tightening cycle could be a catalyst for better stock performance

From Standard & Poor's Equity Research

Rarely has the old saw, “sell in May and walk away,” been more excruciatingly appropriate than in the summer of 2006.

The S&P 500 peaked at 1326 in early May-- its highest close since the first quarter of 2001-- and promptly commenced a prolonged and painful swoon. The guilty party? Fear, specifically fear that those Four Horsemen of the Macroeconomic Apocalypse -- high oil prices, rising interest rates, a weakening housing market, and geopolitical risk -- would kick the U.S. economy into a “hard landing” that would spell the end of earnings growth for the time being.

These fears have been exacerbated in recent weeks by yet more uncertainty: when would the Federal Reserve, led by an untested Ben Bernanke, end its program of interest rate increases? Rising core inflation only clouded visibility, as market participants began to believe that continued upward pricing pressures would cause the Fed to overshoot, thereby forcing the economy into a significant slowdown or even a recession in 2007.

But after four consecutive months of above-consensus inflation readings, we believe last week’s benign producer price index and consumer price index data for July gave investors confidence that the Fed is nearing an end to its tightening campaign.

Economic growth slowed to 2.5% in the second quarter from the first quarter’s blistering 5.6% pace. We expect this modest 2.5% growth rate will continue in 2007, and look for inflation to moderate as the economy cools.

S&P Equity Strategy believes this will likely provide a catalyst for better U.S. equity performance. We think the S&P 500 index is poised to retest its May highs as investors focus on the likelihood of a soft economic landing, which should allow earnings to keep climbing.

We’re also seeing significant improvement in the equity risk-reward ratio. As the chart below illustrates, earnings have climbed 25% since January 2005, while the S&P 500 is up only 6% over the same period. This has left valuations low -- the S&P 500 is trading at just 14.9 times estimated 2006 per-share earnings, despite estimated double-digit profit growth for 2006.

The S&P Investment Policy Committee’s yearend price target for the index is 1315, representing a 7.3% 2006 total return (which includes the index’s 2% dividend yield).

We believe the financials sector -- which is the largest in the market, representing 22% of the S&P 500 -- is uniquely positioned to benefit from an end to the Fed’s tightening program. This sector also sports above-average S&P Quality Rankings, a measure of earnings and dividend growth and consistency over the past 10 years. Our top picks in the financials sector are available on the Sector Scorecard at The Outlook’s website.

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