Midyear outlook: Can stocks regain footing in a lagging economic recovery?

If you don’t think market forecasting is vexing, try this exercise. Imagine you possessed a crystal ball on Jan. 1. You foresaw the natural disasters and nuclear accident in Japan, the world’s third-largest economy. You predicted political and social turmoil across the Arab world, the war between NATO and Libya, and the spike in oil prices. You anticipated that Standard & Poor’s would downgrade its outlook on U.S. government debt to “negative” and intuited that Europe’s national debt problems would worsen. Knowing all that, would you have predicted that U.S. stocks would have returned 5 percent over the next six months?

The question is whether stocks, which teetered in May and began June with a dramatic downswing, can hold their own during an increasingly shaky economy. Unemployment remains high, wages are stagnant, and inflation in food and energy prices is a tax on consumers. Even manufacturing, a source of strength, hiccupped in May. Housing, normally a key ingredient of an economic recovery, is still a disaster. One-fourth of mortgages are under­water, and 40 percent of home sales are distressed properties, which is helping to drive down prices. J.P. Morgan Chase calculates that homeowner equity, a pillar of middle-class net worth, has plunged by about 55 percent, to $6.3 trillion, over the past five years.

Bumper profits

If the stock market is to regain its footing, it will be on the strength of companies’ remarkable earnings. From Apple to Intel, Boeing to United Technologies, they are gushing bumper profits. Companies in the Standard & Poor’s 500-stock index are likely to generate record earnings in 2011. From the stock market’s low point in March 2009, company profits and stock prices have roughly doubled.

The best gains are probably behind us, but U.S. stocks could add 5 percent by the end of this year. That implies that the Dow Jones industrial average will hit 12,800 and the S&P 500 will near 1400, or about 14 times this year’s projected earnings. (The Dow closed at 12,569.87 and the S&P at 1337.88 on Tuesday). Rising dividends and strong merger activity should help support stocks. So will the Federal Reserve Board’s easy-money policies, which are keeping interest rates extraordinarily low and forcing investors to take risks in search of decent returns.

So why are corporate earnings so buoyant? One explanation is the composition of the S&P index. Bank of America Merrill Lynch strategist David Bianco says that 45 percent of earnings are generated by four sectors — energy, materials, technology and industrials — that are closely tied to global economic growth. These days, that growth comes largely from emerging markets, which may account for two-thirds of global expansion this year.

Illustration by Bill Mayer
Shifting landscape

The economic recovery is now maturing into expansion, which implies some shifts in the market. Year-over-year earnings gains will shrink, and investors will grow more discriminating in selecting stocks. Early in the cycle, small and highly leveraged companies perform particularly well. Later in the cycle, says Putnam strategist Jeff Knight, investors gravitate toward larger companies with better balance sheets and more-durable growth.

As you invest, don’t throw caution to the wind. Plenty of risks remain. One challenge will be the end of the Fed’s program of buying Treasury bonds to hold down long-term interest rates. No one knows for sure how the Treasury market will react now that the “QE2” stimulus program has ended, but the action will clearly represent a de facto tightening of monetary policy.

“The market will have to attract real buyers of Treasurys and find out what real demand is,” said Brian McMahon, chief investment officer at Thornburg Investment Management. If an insufficient number of those real buyers show up, bond yields could rise, threatening to derail the fragile economic recovery.

Low interest rates in the United States are raising the risks of higher inflation and a crumbling dollar. U.S. interest-rate policies are out of whack with the rest of the world. For instance, the European Central Bank, worried about inflationary pressures, has been raising short-term rates, while the Fed, under Chairman Ben S. Bernanke, has kept them at rock-bottom levels. That has undermined the value of the dollar, and there’s always the chance that an orderly decline can turn into a rout.

Low interest rates are surely playing a role in soaring gold prices, too. The metal has recently retreated from a record high in May, but bullish underpinnings remain. Foreigners, who buy a lot of U.S. Treasurys, are snatching up the precious metal instead because they are becoming increasingly concerned that U.S. policy is to stimulate inflation, debase the dollar and repay foreign borrowings with cheaper dollars.

The Fed’s money-inflation policy is also contributing to rising food and energy prices. (Most commodities are priced in dollars.) Surging fuel prices have already wiped out the benefits to most households of this year’s two-percentage-point cut in the Social Security payroll tax. We may be nearing the point at which higher oil prices choke off the economic recovery.

Investing overseas comes with its own set of risks. In Europe, the sovereign debt crisis is far from resolved. In June, details of the second Greek bailout in a year were finalized, and worries remained about potential defaults in Ireland and Portugal. A restructuring of debt, in which banks in France, Germany and elsewhere take a buzz cut on their loans, may be inevitable.

Developing nations are growing robustly, but inflation is rising in several places. Especially vulnerable are countries with currencies tied to the shriveling dollar and with a high ratio of food costs in their consumer price baskets, such as in North Africa and the Middle East. Central banks in India and China have been raising interest rates to fight inflation, but their actions may come too late.

Looking abroad

Yet sharp-eyed investors are spotting good value around the globe. Sarah Ketterer, manager of Causeway International Value Fund, said quality stocks are on sale. “You don’t need to go into the junkyard” to find attractive buys, she said.

For instance, she likes Honda Motor, whose shares have been beaten down over concerns about temporary parts shortages after Japan’s earthquake and tsunami. Honda, she noted, is highly profitable, financially strong and growing well in the Southeast Asian and Latin American motorbike markets.

Ketterer is also keen on Swiss drug giants Novartis and Roche, with stocks yielding about 3 percent and 4 percent, respectively.

McMahon, who co-manages Thornburg Investment Income Builder, is also gravitating to foreign companies that pay big dividends. For instance, he holds European oil companies Royal Dutch Shell and Total, as well as telecom outfits such as Vodafone, which owns half of Verizon Wireless, and Australia’s Telstra, whose stock yields a hefty 8.5 percent.

If you want a pro to pick your foreign stocks, consider the mutual funds Harbor International or T. Rowe Price Emerging Markets Stock.

Tanzer is a senior associated editor at Kiplinger’s Personal Finance.

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