BlackRock’s Doll: Modest – but positive – levels of growth will continue

Equities took a break from their four-week run and consolidated gains last week, posting very slight losses

The following is a weekly investment commentary by Bob Doll, chief equity strategist for Fundamental Equities at BlackRock. Mr. Doll is also lead portfolio manager of BlackRock’s Large Cap Series Funds. The opinions expressed are his own.
Equities took a break from their four-week run and consolidated gains last week, posting very slight losses. The Dow Jones Industrial Average was off 0.3% to close at 10,829, the S&P 500 Index dropped 0.2% to 1,146 and the Nasdaq Composite fell 0.4% to 2,370.
Over the past several weeks, economic data has shown signs of improvement, suggesting that the risks of a double-dip recession are lessening. Last week’s good news included the Chicago Purchasing Managers’ Index for September, which showed increases in both production levels and new orders. Additionally, initial unemployment claims declined, a positive for the beleaguered labor market. Outside the United States, data from Germany pointed to a stronger-than-expected recovery and we also have been seeing reasonably firm data from China.
Looking ahead, we expect to see some continued back and forth in economic data. The Federal Reserve is likely to continue to support growth through its policies of ensuring that liquidity remains ample. On the other hand, however, the slowing of the rebound in business inventories, constraints from private-sector deleveraging and balance sheet contraction from the banking system will act as headwinds. On balance, we believe that modest (but positive) levels of economic growth will continue, and in the United States, our 12-month forecast is for real gross domestic product growth of somewhere between 2% and 2.5%.
If this forecast is accurate, these growth levels should be enough to maintain strength in corporate earnings. Corporate balance sheets remain healthy, as most companies have remained very conservative in terms of managing their debt and spending levels. Corporate confidence remains somewhat shaky, but should economic growth continue to improve, companies will likely become more aggressive in deploying their high levels of cash on such activities as dividend increases, share buybacks, capital expenditures, merger-and-acquisition activity and (hopefully) hiring. Over the course of the next year, we expect to see continued improvements in corporate earnings and believe the earnings per share for the S&P 500 could be around the $90 level in 2011, which would represent a roughly 8% increase from the $83 level we are forecasting for this year.
For several months, we have been highlighting the increasing disconnect between the S&P 500 earnings yield and investment-grade bond yields. That disconnect has now spread to the high yield bond sector as well. Treasury yields have declined over the past several months as both recession risks and the likelihood for additional Fed bond purchases increased. At the same time, corporate bond spreads have remained relatively unchanged, which has brought investment-grade corporate bond yields to record lows and high yield bond yields to lows they last reached in the pre-credit-crisis environment of 2007. As a result, the S&P 500 Index is offering an earnings-per-share yield that is as high as high yield bonds, a very unusual scenario and one that speaks to the attractive relative value of stocks.
At present, there are a number of crosscurrents affecting financial markets and many investors lack conviction about how to position their portfolios in the current environment. Some are playing “catch up” from the recent rally, while others are maintaining a defensive posture. In the short-term, we believe continued caution is warranted given the high levels of uncertainty, especially considering the rebound in investor sentiment we have seen, coincident with equities’ 10% rise from their lows about a month ago. Still, assuming the United States does avoid a double-dip recession (which is our view), and that Europe continues to avert a renewed financial crisis, we believe investors with long-term horizons should look past the short-term tactical issues and focus on the fact that equity valuations appear attractive, especially relative to bonds.
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