2011 – A Transition Year
2010 was a very good year for U.S. stocks with the S&P 500 climbing 13% and the S&P 600 small capitalization index soaring 26%. European equities rose 9% while the Shanghai Composite fell 16%. 2010 was an even stronger year for commodities as cotton rose 89%, gold jumped 28% and oil climbed 13%.
For U.S. stocks, the cyclical bull market that commenced March, 2009 continued apace. Change drives the prices of market based assets. In 2010, corporate profits rose 47%, a notable positive change compared to the 15% gain for profits in 2009. Political change brought a new composition of the U.S. Congress and optimism about the future. The biggest change and the one having the most impact on markets was the initiation of QE2 in the late summer. QE2 was designed as an “insurance policy” to support growth and to diminish the risk of deflation. It was also started to encourage risk taking and higher asset prices.
In assessing the outlook for the U.S. stock market, we should consider the prospects for the aforementioned market drivers for 2011 as well as defining other factors that might influence the course of the markets. As 2011 begins, the economic fundamentals are increasingly supporting more growth than experienced in 2010. Economists are projecting 3.5% growth in 2011 compared to 2.5% in 2010. This potential pickup in growth is important for the outlook for corporate profits. The strong earnings gains in 2010 were largely the result of cost cutting providing a boost to profit margins. In 2011, it is unlikely that margins will grow as much as they did in 2010. Consequently, increasing revenue growth will become a more important determinant for profits growth. With the economy now expected to grow more quickly in 2011 than in 2010, profits are expected to climb 13%, a significant follow on to the 47% earnings gain in 2010. In our opinion, stock valuations, especially in the large cap sector, do not reflect continuing significant growth in profits. Consequently, the profits outlook supports a rising market trend.
If the economy gains further momentum in 2011, then QE2 may no longer be needed to support the economy. Banks have recently become more active lenders and may continue to do so in 2011. Risk taking has generally increased and may expand further in the months ahead. Prices of more things are rising. Thus, it is likely that the QE2 will end in the months ahead. This prospect may produce volatility in stock prices at some point in what has been a liquidity driven market. Barring a setback in the economy’s improving growth path, the Federal Reserve may no longer provide the degree of liquidity that it has. This possibility would represent a significant change in policy and would remove a key support to the stock market. Having raised the prospect of the end of QE2 and no similar policy to follow, it should be added that the market outlook should not turn from bullish to bearish as improving fundamental growth in profits would become the principal driver of market prices. If the Fed were to tighten monetary policy, then the outlook would turn bearish. It is more likely that the degree of monetary stimulus will lessen, than it will end.
The political setting could have an impact upon the market. With the majority in the House of Representatives, Republicans should be looking to build on their gains. Concomitantly, the President should be thinking about winning back voters in 2012. Voters are generally concerned about the long term fiscal health of the country. Knowing this, both political parties should work positively on a program to deal with long term fiscal issues. The Bowles-Simpson committee has weighed in on this. Moreover, the Paul Volcker led Economic Recovery Advisory Board produced a 118 page document dealing with tax reform. Recently there has been speculation about a cut in the corporate income tax rate. This action would likely require broadening and simplifying the corporate tax base. Winners and losers would result. Heavily subsidized sectors of the economy might be at risk. While there is skepticism about the chances of any real progress on fiscal reform, we would not disregard the possibility of progress. Meaningful progress would be bullish for the stock market overall and might have the potential of turning a cyclical bull market into a secular bull. This prospect could be a major surprise in 2011.
Speaking of surprises, there are many others, both positive and negative, that might occur in 2011. Better than expected employment and housing, most likely later in the year, are two that come to mind. In the first half, rising consumer prices, including gasoline, could bring some slowdown in consumption. Interest rates rising more than expected during the year is another possible surprise.
Outside the U.S., growth is likely to slow a bit in China and possibly in the emerging markets, especially if a further rise in commodities’ prices forces monetary tightening. In Europe, there may be further country financial issues in Spain and Italy. Meanwhile, recovery growth will be slow in much of Europe.
Returning to the U.S., we expect a strong year for mergers and acquisitions. With corporations cash rich, borrowing capacity increasing and both buyers and sellers more motivated to do deals than they have been in recent years, we expect to see a marked pick up in transactions in 2011. We also foresee a number of share buy backs and the second year in a row of dividend increases. All of the aforementioned actions will lend further support to the stock market.
Another factor in the markets during 2011 may be a rising tide of initial public offerings (IPOs). In 2010, about 26% of IPOs were Chinese companies. We expect to see an increasing number of U.S. companies come to the market. Private equity managers are motivated by the stock markets rise to bring more of their holdings public. Moreover, some major internet firms, such as Facebook, Twitter and Groupon, are tipped to come public during the year. An increasing number of IPOs in 2011 may produce more exuberance in the market at some point.
In our October 28 commentary, we discussed the likelihood of stocks outperforming bonds over the next year. We continue to expect this outcome and have advised clients to reduce bonds and increase equities exposure. One of our reasons for suggesting this shift has been the belief that individual investors would sell bonds and buy stocks. In fact, that is what individuals are starting to do. According to Investment Company Institute (ICI), individuals put $390 million into stock funds in November after a $24 million outflow in October. During November, bond funds had $875 million in outflows compared to $24 billion of inflows during October. On a more current basis, ICI has said that $335 million flowed into stock funds for the week ended December 21. Meanwhile bond outflows were $4.37 billion. Thus, it appears that the individual is moving away from bonds and into stocks. While this shift may cause some cynics to raise their eyebrows, we believe this change will continue over time. Like the currently bullish investor sentiment toward stocks, the movement by individuals to stocks may coincide with a selloff in stocks over the near term, but we suspect this shift to stocks from bonds will continue over time.
From a strategy perspective, we continue to emphasize stock funds, primarily U.S., over bond funds. We would be a bit more diversified than usual with exposure to both growth and value. Growth was the winner in 2010, but value has picked up interest in December as analysts raised their estimates for U.S. economic growth in 2011. We believe large cap is better value than small cap, but the latter may see more exuberance in the months ahead. We are reluctant to put new money in emerging markets now. On a value basis, developed markets outside the U.S. have appeal.
In the alternatives area, we continue to favor distressed and event driven funds and we also continue to like selected long/short hedge funds. Real estate is interesting to us while private equity does not hold attraction.
Overall we would emphasize the use of alpha driven strategies compared to beta driven ones that may have served investors well in the past two years.
We wish our readers a happy and prosperous New Year.
A. Marshall Acuff, Jr., CFA
Director of Research
Chair, Cary Street Partners Investment Committee
Cary Street Partners Investment Advisory, LLC