Outlook 2011: Should You Be as Bullish as Wall Street?

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David G. Dietze, JD, CFA, CFP
Dec 28, 2010
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2010 is ending on an upbeat note. The year started strong, as a constructive economic outlook caused pundits to wonder how the Federal Reserve was going to reduce monetary stimulus before the ill winds of inflation started blowing.

By April 23 the market had advanced some 10%. But, concern over inflation was soon pushed aside by fear over European sovereign debt defaults, the poster child being Greece. Traders reduced risk, the dollar soared, the Euro plunged, and worries over a "double dip" in the economy dominated. The market corrected nearly 17% by early July, as interest rates drifted lower.

The catalyst for the market's sprint to a strong finish was Mr. Bernanke's (Federal Reserve Chairman) speech on August 27. He conceded that there was "unusual uncertainty" on the economic outlook, but said the Federal Reserve was prepared to use "unconventional measures" to ensure a recovery, including purchase of longer dated securities.

While the specific plan to purchase up to $600 billion of longer dated Treasuries was not announced until November, the market immediately began to price in the stimulus; September and October turned in their best joint market performance since 1998, while the yield on the ten year Treasury plunged to 2.38% on October 8.

Now, with the end of the year just a few days away, the S&P is up 11.57%, reaching highs last seen before the collapse of Lehman in September, 2008. The market has been up 14 of this month's 16 trading days, on track for its best December performance since 1987.

Wall Street market strategists are uniformly bullish, generally forecasting 2011 gains of 10% to 17%, with Deutsche Bank forecasting gains of as much as 25%. Truth be told, Main Street investors have gotten just as ebullient, if not more so: Recent polls indicate the greatest level of optimism since 2007, with the bullish crowd surging to 63% of those queried, with just 16% claiming bearishness.

Given this bullishness, should you be as optimistic?

Forecast In a Nutshell

2011 should be approached cautiously but we still expect returns to be in the 6% to 8% area, with another 2% in dividends.

Corporate earnings should rise to record levels. Valuations, particularly when judged against the meager yields on risk free assets like Treasuries, remain attractive.

The economy appears to be gaining strength, as factory utilization improves, retail spending returns, and leading economic indicators remain positive. Confidence in the corporate board room, coupled with bountiful cash on the balance sheets, could lead to increased merger and acquisition activity. That would further boost sentiment.

On the other hand, much of the better news has already been discounted. Three straight years of positive performance has only been achieved twice since World War II. In those cases, the third year saw average returns of just 1.7%.

Other 2011 headwinds include European sovereign debt concerns, a still moribund housing market, surging interest rates and soaring commodities, together with efforts by China to cool its economy.

Valuations Coupled With Low Interest Rates: Your Most Bullish Factor!

S&P 500 companies could generate $95 a share next year in earnings. Given that the S&P index is roughly 1250, you've got a market trading at just 13 times next year's earnings, a nice discount to the last decade's average of 16. If the market were to trade up to that 16 price to earnings ratio, you'd see a 21% return!

A 13 multiple is especially reasonable in light of today's low interest rates, as it equates to an "earnings yield," the inverse of the price to earnings ratio, of 7.56%. Compare that with today's ten year Treasury yield of just 3.38%. That 4%+ spread, the so called risk premium, is quite attractive, hearkening back to the early 1980s.

Of course, the spread could close by the Treasury yield climbing; indeed it has already risen over 1% since early October.

Moreover, the dividend yield on the S&P 500 is below 2%. The bearish take is that this is well below the historical average of 4.35%; the last time yields were this low was in 2000. The bulls point to an impending avalanche of dividend increases, given the better tone of the economy and the abundant cash on corporations' balance sheets.

Bullish Fiscal and Monetary Stimulus Backdrop

The Obama/McConnell tax package, while perhaps a mistake long term due to its budget busting implications, will undeniably stimulate consumer spending. Economists are already ratcheting up GDP forecasts to numbers with a "3 handle" as opposed to a "2 handle".

On the monetary side, the Federal Reserve is hell bent on further easing via non conventional Treasury purchases. It is "100% confident" according to Chairman Bernanke that if ultimately inflation is the byproduct it can shut that down quickly and efficiently.

Keeping interest rates low will spur borrowing and drive investors to riskier assets to improve returns. But, will the Federal Reserve intervention spook bond investors as they fret over inflation: Since the announcement of the Fed's decision to purchase over $600 billion of Treasuries the ten year Treasury's yield has actually risen nearly 1%.

But, Macro Problems Lurk

The Euro sovereign debt crisis appears to be an abscess that just won't respond to the Euro Central Bank's bandages. What will it take, is there the political will to do it, and will it come in time? Will default/restructuring/"haircut" of the sovereign debt of one of the PIIGS (smaller countries on Europe's periphery) prove to be "Lehman 2.0"? After all, European banks hold most of this debt, and its unraveling could rattle these banks and in turn the entire global financial system.

China Tightening

Inflation and real estate bubbles are proving to be problems in China. Can the Chinese arrest the problems, and what will be the global fallout given that the rest of the planet relies so heavily on China? If China fails to tighten, will its voracious demand for commodities trigger inflation elsewhere?

US Housing

It is not at all clear that a bottom in residential real estate has been reached, much less an upturn appeared, as the disdain for leverage and real estate generally, plus a weak economy, more stringent mortgage loan standards, and expiration of tax credits for buyers continue to weigh. Given that consumers' homes are typically their largest asset, weakness here sours sentiment and renders impotent the home equity ATM that powered economic strength for years.

Now, much higher mortgage rates, boosted by the recent backup in the Treasury market, threaten to further queer the housing recovery. For example, the 30 year mortgage rate recently hit 4.83%, nearly two-thirds of a percent higher than the 4.17% of five weeks ago. But, rates are still very low, and that 4.17% rate was the lowest since at least 1970.


Despite recent improvement in weekly jobless claims, the November uptick in the jobless rate to close to 10% and a worse than hoped for job creation rate suggests the burden is on those who would argue that the employment market is improving. The small number of jobs being created is not sufficient to absorb all the net new job seekers coming into the market.

With the consumer 70% of the economy, until the job market is again healthy, our economy and therefore corporate earnings are very much at risk.

How to Make Money in 2011?

The tried and true method of seeking out large franchises, solid dividend yields, low valuations, and out of favor sectors is still a favored strategy for 2011.

Few areas of the investment world have been as pummeled as Europe, particularly in the so called Club Med region, meaning countries like Greece, Portugal, Ireland, Portugal, and Spain.

Banco Santander (STD, Financial) has been beaten down due to the knee jerk response to sell anything and everything in Spain. However, despite a Spanish headquarters, less than 25% of its operations are there.

STD is the world's seventh largest bank and one of the largest in Europe, with major operations in both Latin and North America. Thus, you get exposure to fast growing regions like Brazil but at an attractive valuation of just seven times earnings. Analysts estimate that if you back out STD's non Spain activities, you are paying just 3 times earnings for its Spanish operations. While you wait for the region to stabilize enjoy the 5% dividend. This bank never took TARP nor eliminated its dividend.

Exelon (EXC, Financial): Not just another electric utility as EXC is the country's largest nuclear operator, generating 17% of all nuclear fueled electricity in the country, and 4% of all electricity. It offers a great hedge on higher fossil fuel prices and or increasing regulation of emissions. Its regulated units (ComEd and PECO) may see rate increases as regulators relax rate caps following some economic improvement and few recent increases.Utilities' defensive characteristics are a plus if the much ballyhooed domestic economic recovery stalls. Meanwhile, EXC's attractive 5%+ dividend may attract investors migrating over from low yielding, now volatile, bonds.

Large pharmaceuticals are very out of favor, but Pfizer (PFE, Financial) offers promise. Its recent acquisition of Wyeth broadens its pipeline and gives it cost cutting opportunities. It enjoys tremendous economies of scale, as it boasts the largest drug sales force and R&D efforts on the planet.

It's the cheapest stock in the Dow by P/E (7.3) with generous 4.7% dividend. Its $22 billion of cash makes possible potential acquisitions, stock buy backs, and dividend hikes. Its new CEO, Ian Read, appears well qualified with 30 years experience at PFE.
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