Adam S. Parker, Ph.D.
US Equity Strategist
Our 2014 forecast for the S&P 500 Index is 2,014. That may look like a big number, but it doesn’t take a giant leap to get there. It represents 9% potential upside from the 2013 close, driven by our estimate of 6% operating earnings growth, net 3% share repurchases and modest expansion of the forward price/earnings (P/E) multiple. Relative to our prior view, this represents about a 0.8 turn more in the P/E multiple—and there is potential for more. The low dispersion of price/forward earnings and higher company-specific risk lead us to conclude that a more concentrated portfolio will be prudent this year.
Since last March, we have been sanguine on US equities. Our logic has been driven more by lack of a bear case than the strength of the base case. We have seen three turns of multiple expansion in the last two years as the P/E moved to 15.1 from 12.0—only the fourth period with this level of expansion over the past 40-plus years. Obviously, a sample size of three isn’t statistically significant, but the prior three periods were followed by a continuation of the rally for another 12 to 24 months, as momentum typically persists. The only thing people are worried about currently is that no one is worried about anything, which isn’t a real worry.
In order to time the impossible—the inflection point—we remain focused on what could cause fear about a materially lower earnings trajectory, or even what could introduce volatility into the earnings estimates. The answer: not much right now. We need to see more capital spending, hiring, inventory and mergers-and-acquisitions activity in order to be more fearful of a material earnings decline as these costs get put in place and turn out to be imprudent. We would look for backlog extensions from the technology and industrials companies or increases in book-to-bill ratios as signs demand is improving and spending is imminent. The most pronounced risks remain: demand weakness in the emerging markets, which has been indicated by some large US multinationals; a policy error from the Federal Reserve; and a strengthening dollar, which can be a drag on profits earned overseas by US companies.
With a 2% dividend yield, a 3% net buyback and mid-single-digit earnings growth, a big down market is akin to calling for a double-digit contraction in the market multiple. We don’t think that’s likely. We are still optimistic and wouldn’t be surprised to see the S&P 500 remain robust. Our target for 2014 will likely be above Wall Street’s consensus. The dream of a steeper yield curve, a belief that the Fed can distinguish between tapering and tightening, and the lack of a credible bear case in earnings could drive further multiple expansion. Upside from economically stronger China and Japan could also help. In fact, it isn’t preposterous to say that we could be in an environment of synchronous global economic expansion in 2014 that isn’t fully in today’s prices.
At the sector level, we are upgrading materials to overweight from equal weight, a move driven by chemicals. We are also downgrading industrials to equal weight from overweight and lowering energy to underweight from equal weight. In addition, our strategy recommendations include a preference for small caps over large caps, and we recommend a barbell-like approach, holding both cyclical and defensive companies. We prefer health care to consumer staples, technology to consumer discretionary and chemicals to industrials and energy. Within financials, we prefer capital-market-sensitive banks and asset managers over insurers and regional banks.