The Stock Rally May Still Have Legs in 2011

If strategists at Wall Street's biggest banks have it right, the Standard & Poor's 500-stock index is heading for its biggest three-year advance since the 1990s. The benchmark gauge for American equities will rise 9 percent from its Dec. 27 close, to 1,374, by the end of 2011, according to the average forecast of 11 strategists in a Bloomberg News survey. That would bring the cumulative increase in stock prices since 2008 to 54 percent and make for the best three-year return since 1997 to 2000.

The 11 forecasts range from a high of 1,550 to a low of 1,250. In January the average strategist forecast was for the S&P 500 to finish 2010 at 1,225. It closed at 1,258 on Dec. 27. Market analysts say earnings will hit record highs in 2011, keeping valuations below historical averages at a time that government spending aids the economy.

Goldman Sachs' (GS) David Kostin, the most accurate U.S. strategist of 2010—he predicted the index would finish at 1,250—says sales growth will send the S&P 500 up 15 percent, to 1,450, through the end of 2011. "Company balance sheets have never been stronger," he says, citing Goldman Sachs data showing corporations hold more than $1 trillion in cash, the most ever relative to the value of their assets. "We expect S&P 500 firms will increase spending in all categories, with the fastest growth in acquisitions and share repurchases." He is the second-most-bullish of the strategists surveyed.

Barry Knapp, the New York-based head of equity strategy for Barclays (BCS), expects the S&P 500 to reach 1,420. "I've tried to think about all the risks," he says. "I just think the outlook is favorable, so favorable that I struggle to see how the equity market doesn't perform well."

One potential risk is shrinking profit margins, according to Citigroup's (C) Tobias Levkovich, who estimates a 3.3 percent gain for the S&P 500 next year, to 1,300. That's the second-most pessimistic projection of the 11 strategists. While Levkovich is upbeat about the first six months of the year, saying the market could exceed his estimate as businesses spend and confidence returns, the second half won't be as positive. He's concerned that profit margins, which have expanded to the highest levels since 2007, may begin to shrink.

The strategists in the Bloomberg survey predict S&P 500 combined profits will reach $92 a share in 2011. The index trades at 13.5 times that estimate, compared with a median price-earnings ratio of 16.4 since 1956, according to data compiled by Bloomberg. The S&P 500's earnings yield, or annual profit divided by share price, was 6.45 percent on Dec. 13. That was 3.13 percentage points more than payouts on 10-year Treasuries and about 2.4 points more than the average interest on U.S. corporate bonds as measured by Barclays.

The spread between the S&P 500 earnings yield and corporate bond yields is close to the widest in more than two decades. That suggests stocks are more attractively valued than bonds, which may spur investments by individuals, institutions, and companies in 2011, Kostin says.

Jonathan Golub at UBS (UBS) in New York expects a 5.3 percent rise, to 1,325, in the S&P 500 through 2011, fueled by sales growth of as much as 7 percent for companies in the index. Next year looks "good, with a chance of great" for equities, he says. "We're entering into a self-sustained recovery." Record cash means companies can increase mergers, acquisitions, and share repurchases, Golub says.

Earnings valuations based on profit estimates for 2011 show prices have been depressed by an overly pessimistic view of the economy, he says. "As the economy continues to surprise on the upside, there's a process by which the market starts to discount greater success," says Golub. "I'm not calling for a lower-return year."

The bottom line: Prospects for strong earnings, plus the cash on balance sheets, have strategists seeing a 9 percent gain for the S&P 500 in 2011.

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