A Good-Bad Economic Outlook

There's discord on Wall Street: Strategists at major American investment banks see a double-digit stock rally in the second half, even as economists—sometimes at the same firms—are trimming their 2010 forecasts for the U.S. economy.

Tom Lee, chief U.S. equity strategist at JPMorgan Chase (JPM), says rising profits will drive the Standard & Poor's 500-stock index up 16 percent by yearend, while the firm's chief economist, Michael Feroli, argues declining factory orders are cutting economic growth. At Bank of America (BAC), head of U.S. equity strategy David Bianco predicts the S&P 500 will reach 1,300, up from a current 1,121, thanks to record low interest rates; his colleague, chief economist Ethan Harris, says changing financial regulation is causing the economic expansion to slow.

"Both can be right, in the sense that you can have a slowdown in the rate of growth within the economy, which is what most economists are calling for, but still continue to see earnings grow," says Bruce McCain, chief investment strategist at Cleveland-based Key Private Bank, which manages $25 billion. "The cautiousness with respect to the economy is actually enhancing earnings because they're slowing down investments that would be a drag."

The fastest annual earnings increase in 22 years will push the S&P index up 20 percent in the last six months of 2010 to 1,242, according to the average projection of 12 firms compiled Aug. 3 by Bloomberg. Cash at S&P 500 companies has risen six straight quarters to $836.8 billion as executives have fired workers and reduced capital spending, according to S&P. Earnings at the same companies will increase 35 percent in 2010, the biggest annual gain since 1988, according to more than 8,000 analyst estimates compiled by Bloomberg.

While corporate earnings are increasing faster than predicted, gross domestic product growth trailed forecasts in the second quarter. JPMorgan's Feroli says a slowdown in manufacturing and a plunge in factory orders are bigger drags than government data have reported. He says second-quarter expansion was almost a percentage point below the estimated 2.4 percent annual rate reported July 30 (revised data are due out on Aug. 27). He expects unemployment to remain near 9.5 percent this year.

"There's a tug-of-war right now between people who look at the economic data and say it's still pretty disappointing, even a double dip, and other people who are looking at business trends and thinking the recovery is under way," says John Carey, a Boston-based money manager at Pioneer Investment Management, which oversees about $230 billion. "Corporate earnings are what really matter at the end of the day to investors, not economic forecasts."

The bottom line: Wall Street equity strategists see a stock rally in the second half, even as economists see headwinds aplenty for the U.S. economy.

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