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By Sam Stovall Three-quarters of the way through January -- when the S&P 500-stock index was off 3.6%, and the S&P SmallCap 600 was down 5% -- it appeared to us at Standard & Poor's that investors were adjusting their expectations to include additional "disappointment factors" into their 2005 investment outlook, among them the possibilities that:
Oil prices could hover at or above $50 per barrel, rather than fall to around $40, as had been previously expected
Future S&P 500 operating earnings growth might only meet -- not beat -- expectations this time around
Inflation may begin to accelerate above the projected 2.5% level for 2005
The Fed would, as a result, start raising rates faster than expected -- maybe even by 50 basis points at its March meeting
yield curve would signal slowing gross domestic product growth and the possibility of a recession.
But here it is in mid-February, and the index has reversed its losses -- and some of last month's gloom may have dissipated. What happened to change things? Let's run down the list.
Oil: It certainly looked like oil prices would do their part to dampen investor spirits. Just before the first major snowstorm in the Eastern U.S. this season, oil traders began pushing up prices to near $50 per barrel on concerns that the 2004-05 heating season would be colder than normal.
With fewer than six weeks remaining in groundhog Punxsutawney Phil's forecast, however, it now appears that this winter will actually be warmer than average, allowing inventories to improve and prices to fall. This adds credibility to Global Insight's projection that West Texas Intermediate (WTI) oil prices will average $46 for the first quarter of 2005 and then edge toward $40 by yearend.
Corporate Profits: Earnings growth has also brought some cheer. As of mid-February, more than 80% of the companies in the S&P 500 have reported fourth-quarter 2004 earnings, and actual results may again exceed expectations, as they have for the past two years.
Indeed, entering into this profits-reporting period, S&P's equity analysts projected operating earnings to increase 17%, on a year-over-year basis. But as of mid-February, it now looks as if earnings will actually climb 22%, led by upside surprises from the energy and materials sectors.
In particular, integrated oil and gas behemoths ExxonMobil (XOM
; S&P investment rank 4 STARS, buy; recent price, $56) and ChevronTexaco (CVX
; 5 STARS, strong buy; $57) posted significantly better-than-expected results, in part from strong refining and marketing margins, as well as improved industry conditions. In the materials sector, companies in chemicals, diversified metals, industrial gasses, and steel groups posted better-than-expected results from increased pricing and strong demand.
Earnings Progression During the Reporting Period
Sector or Index
For 2005, S&P analysts haven't increased their earnings projections in the aggregate, which should make comparisons with 2004 more difficult. Our analysts project that the S&P 500 will post a 9% year-over-year earnings increase for the full year, led by double-digit increases in industrials, information technology, materials, and utilities.The Fed Outlook: The unexpected strength in corporate profits wasn't the only "February surprise" for investors. Wall Street expected nonfarm payrolls to rise 185,000 in January. However, the jobs report for the month, released on Feb. 4, showed payrolls increasing by only 145,000. What's more, the unemployment rate slipped to 5.2%, because fewer people looked for work. Investors took this as a welcome relief that the economy isn't growing above expectations, and thus removing the need to upwardly revise estimates of inflation.
As a result, we think the Fed's "measured pace" approach to raising short-term interest rates by 25-basis-point increments will likely not be derailed anytime soon. S&P expects the central bank to continue raising short-term rates throughout the year, putting the Fed funds target rate at 4% by yearend and pushing up the yield on the 10-year Treasury note to 5%.
We also expect job growth to average 192,000 per month this year, and see the unemployment rate dipping to 5.1%. Finally, David Wyss, S&P's chief economist, projects that inflation will remain under control, posting a 2% increase in the consumer price index and a 2.1% advance in core CPI, which excludes volatile food and energy costs.
The Yield Curve: With rates rising, this important gauge of the economy's health will be in focus as the year progresses. The yield curve, or the difference between the yield on the 10-year Treasury-note and short-term interest rates, is usually a harbinger of coming economic conditions.
A steepening yield curve typically signals economic expansion (and the accompanying inflationary uncertainties), whereas a flattening yield curve usually indicates that inflationary expectations are lessening as the Fed raises short-term interest rates. An inverted yield curve (where long rates fall below short rates) generally causes investors to worry that the Fed has gone too far with its tightening program and will likely throw the economy into recession.
Even though the Fed has raised short-term rates 150 basis points since June, 2004, the spread between long and short rates has narrowed to 1.7 percentage points from 3.4. This narrowing was due, in our opinion, to factors including the Fed's well-telegraphed retreat from an "accommodative" monetary policy to a "neutral" one, an approach that will be enough to end economic stimulation, but not enough to invite recession.
The shrinking spread may also arise in part from foreign central banks' purchasing of U.S. Treasury securities in order to help peg their currencies' value to the U.S. dollar. It's worth noting that while the 1.7-point spread between long and short rates might seem high, it's still more than 60 basis points above the average since 1971.
Additional points of interest regarding yield spreads:
The 3-month/10-year spread has hovered around its long-term average for years without signaling an impending recession.
But once the spread turned negative (thus inverting the yield curve) a recession usually followed. The only exception was in 1998, as a result of the Fed's effort to offset the negative effects of the collapse of the Long Term Capital Management hedge fund.
Prior to 2001, the 3-month/10-year spread typically traded well below the Fed funds rate, and it traded at a premium by only eight basis points during the third quarter of 1992. Yet from November, 2001, through November, 2004, the spread traded at a premium to the Fed funds rate by an average 151 basis points as the Federal Reserve purposely became more accommodative in order to stimulate the economy and offset the effect of an imploding stock market.
What do all the above factors tell us about the stock market's prospects this year? Even though rising interest rates, decelerating corporate earnings gains, and the aging of this bull market may cause equity returns to fall short of their long-term averages, S&P's Investment Policy Committee does not believe the U.S. equity markets are likely to end their bull runs in the near term.
Why? Global economies are projected to grow between 2% and 7% in 2005, with the U.S. projected to post a 3.7% advance in real GDP. Corporate cash levels remain very high, in our opinion, with more than $600 billion on the books of companies in the S&P 500. In addition, it's estimated that corporations will repatriate between $100 billion to $200 billion in foreign earnings. This capital will likely induce managements to repurchase shares, raise dividend payouts, increase acquisition activity, or spur additional R&D investment.
SUPERIOR PICKS. Our yearend 2005 target for the S&P 500 remains at 1300, for a 7.3% full-year price change. While that's nothing to sneeze at, it will trail the growth of the last two years by a wide margin.
Where do the opportunities lie, then? The S&P Equity Research group believes there will be few leadership sectors. Improved results, in our view, will likely come from superior stock selection rather than industry rotation. Our 5-STARS, or strong buy, list has 110 stocks listed. Each of the 10 sectors within the S&P Composite 1500 is represented.
What's more, 60 of these issues have market values below $10 billion. Smaller-cap issues usually fall out of favor with investors as the bull market ages and interest rates increase. Yet this time around, it seems investors are unwilling to sell those stocks that held up relatively well during the bear market of 2000-02, especially since S&P SmallCap 600 operating earnings are projected to advance 19% in 2005, vs. the 9% anticipated for the S&P 500 -- and yet the p-e valuations of the two indexes are separated by only one percentage point.
What does S&P consider the most attractive issues in the SmallCap 600? Here are some of the 5-STARS stocks in the index:
Steak 'n' Shake
Watts Water Technologies
5-STARS (Strong Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis.4-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis.3-STARS (Hold): Total return is expected to closely approximate the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis.2-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index and share price is not anticipated to show a gain.1-STARS (Strong Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis.
As of December 31, 2004, SPIAS and their U.S. research analysts have recommended 26.5% of issuers with buy recommendations, 61.3% with hold recommendations, and 12.2% with sell recommendations.
All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.
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This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"), and may have been provided to you either by: (i) Standard & Poor's under a license agreement with The McGraw-Hill Companies, Inc., which holds the copyright to this report; or (ii) a Standard & Poor's client who is granted a sub-license by Standard & Poor's. This equity research report and recommendations are performed separately from any other analytic activity of Standard & Poor's. Standard & Poor's equity research analysts have no access to non-public information received by other units of Standard & Poor's. Standard & Poor's does not trade in its own account. SPIAS is affiliated with various entities, which may perform services for companies covered by the recommendations in this report. Each such affiliate is operationally independent from SPIAS.
This material is based upon information that we consider to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results.
This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments, or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations, or needs and is not intended as a recommendation of particular securities, financial instruments, or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Stovall is chief investment strategist for Standard & Poor's