By Bill Stone of PNC Wealth ManagementIt is an intensely hot day, all things on land and sea being merely variations and shapes of flame, wonderful to look upon but not wholly good to be amongst. -- William Vaughn Moody, American poet and playwright As the summer weather here on the East Coast has heated up, the global stock markets have continued to melt under the bright sun. As much as investors enjoyed the S&P 500's first-quarter gain of 5.39%, all that and more fell to the wayside as the index slumped, down 11.43% in the second quarter. This has left investors wondering if the market has another 2008-style rout in store.
One could pick from any number of indicators to point to an oversold condition in stocks. For example, the percentage of stocks closing above their 200-day moving average was 27%. This is the lowest number since the market recovery began in Spring 2009. While oversold stocks can certainly remain oversold, it does reflect the increase in opportunities for bounces on even the absence of bad news. This might explain the early positive market action on Tuesday. This is probably a close cousin to the oversold condition, but market sentiment has turned decidedly bearish. As measured by the American Association of Individual Investors, there are now almost 20 percentage points more bears (42%) than bulls (25%). This is certainly a positive since a higher bearish percentage is a contrary indicator and correlated with higher expected future market returns. Second-quarter earnings season begins for the S&P 500 companies next week. Consensus estimates call for year-over-year earnings growth of a little more than 27% for both the headline number and excluding Financials. Though the combination of earnings estimates being raised in the wake of a great first quarter, a stronger dollar, and a softer economic environment in the second quarter will likely keep the surprises from being as good as they were in the first quarter, we forecast a high likelihood that actual earnings will again outpace estimates. While much attention will be paid to company outlooks rather than earnings from the past, we enter this earnings season on the heels of a poor market environment rather than following explosive upward moves like the last two seasons. Some good earnings news in a market with low expectations could provide a needed boost. With a good portion of worries regarding the global economic situation due to worries about the eurozone banking system, many market participants are eagerly awaiting the results of the eurozone bank stress tests. While there are many questions surrounding these tests, the U.S. stress test experiment provides a successful blueprint. The result should be reported in July perhaps as early as the middle of the month.
Though valuation is a poor timing tool, it is the best long-term predictor of future returns in our opinion. The S&P 500 now sells for roughly 12.5 times 2010 estimated earnings and has a dividend yield of about 2.1%. According to BCA Research, the S&P 500 also sells at the lowest 12- month forward earnings multiple (around 11 times) since 1994 aside from the 2008 plunge. These valuations also compare favorably with 10-year Treasury bonds yielding 2.94% (34 times interest payments) and Baa corporate bonds yielding 6.04% (16.6 times interest payments).
If, as we expect, there is no double-dip recession, stocks provide value and an attractive risk versus reward for investors with a sufficient investment holding period and ability to withstand the market volatility. We believe the relative performance of stocks to bonds and cash should remain attractive when viewed over a reasonable investment period. PNC currently recommends a baseline allocation in our asset allocations in terms of stocks versus bonds and cash, but we recommend a tactical allocation to leveraged loans within the bond allocation in order to reduce interest-rate risk within portfolios. This allocation is an expression of our baseline view that the recovery should continue, which will likely necessitate higher interest rates at the very least. Our current recommended allocation attempts to balance the relative attractiveness of stocks and other risk assets, given the improvement we expect in the global economy, with the downside risks to our forecast. Volatility may remain for some time as the market struggles to get clarity on the sustainability of the global economic recovery and investors should focus on an allocation to balance that risk with the need for growing purchasing power over time.