U.S. Value Equity
Punished Markets Go Back for More
At the start of 2009, equity markets still sat cowering in the corner, showing no signs of recovery from the most severe double whammy they had faced since the Great Depression: the liquidity crisis set off by the failure of Lehman Brothers, followed by a severe recession. By the beginning of March, the S&P 500 was down 25% for the year.
Then, like a toddler who emerges from a time-out and plunges right back into play, the market seemingly forgot its troubles and rebounded. Over the six months from March 9 to September 30, the S&P 500 jumped nearly 56% in a full-scale pursuit of risk. Financials, which were at the root of the crisis, were the best performers, rebounding an astounding 140%. High-beta stocks outperformed lower-beta stocks and small caps outperformed large caps to ring up large gains. It was as if the market learned nothing from the time-out imposed by the financial crisis.
The fourth quarter so far has been extremely volatile. A sharp correction in October was followed by new highs in November. While today's valuations have not reached the extremes of the bubble peaks, they are still stretched. The economy is still not fully out of the woods. Economic improvements have been slow and labored and the market is searching for direction.
Good, Bad and Ugly in the Coming Year
We see some bright spots that should help the equity markets in 2010.
- Financial markets and the economy have stabilized somewhat. As a result, uncertainty, which is always bad for the market, is slowly ebbing. That reduced uncertainty should cause a tailwind for 2010 performance.
- Year-over-year earnings comparisons will remain favorable throughout most of 2010, as figures are weighed against last year's recessionary levels.
- Rebuilding inventories, which are at relatively low levels in many industries, should help to sustain earnings.
Some unknowns remain.
- Health care reform is looming over the health care sector. Until the final structure has been determined and the market sifts out winners and losers, health care stocks will face continued challenges.
- Weak commercial real estate and commercial lending remain a significant concern for the banking sector. The potential scope of the weakness and resulting write-offs are not fully reflected in bank balance sheets.
And real dangers persist.
- Weak consumer credit and consumer demand will most likely continue, threatening operating performance of consumer stocks.
- Housing inventories remain high. Starting in 2010, we will begin to see a wave of option mortgage resets to higher interest rates, potentially leading to another wave of foreclosures and a surge in housing inventory. Until that supply declines to normal levels, housing and housing related stocks will remain under pressure.
- Profit margins and productivity have provided some of the only bright news for stocks through the recession and its aftermath. However, it will be difficult to sustain profit margins at the current levels and we expect modest declines in 2010.
- Management at public companies have been selling their holdings of company stock at a greater rate. This trend signals that the equity rebound lifted expectations for equities to unrealistic levels. Valuations are stretched and may come under pressure.
Small Gains Expected for 2010
We expect the S&P 500 to gain 5%-8% in 2010. Small cap stocks may perform similarly to large cap stocks, perhaps up 4%-6%, but are considerably riskier, given their recent strong relative performance. Earnings are likely to grow marginally in 2010, but probably without a boost from productivity gains. In fact, we expect margins to face some pressure and possibly to shrink from current 6+% levels into the high-5% range. Finally, we expect P/E multiples to revert to more normal levels throughout the course of the year. We anticipate that those shrinking multiples will put a cap on market appreciation, even as earnings growth resumes.
