Tue, Jan 18, 2011, 2:41PM EST - U.S. Markets close in 1 hr 19 mins
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The big picture might look scary, but the stock market is heading higher, say the members of the 2011 Barron's Roundtable. In the first of three installments, our panelists share their big-picture views. More from Barrons.com: • Two-Pronged Bullishness • Facing Up to $4 Gasoline • Intel's Own Version of Survivor
From the halls of Congress to the malls of California, we've been kicking the can down the road. Postponing our troubles, inflating our bubbles. Putting off, for tomorrow and tomorrow and tomorrow, the crushing problems that cry out to be dealt with today. Is this any way to run a country? Based on the stock market's stellar performance in the past two years, you bet it is.
The members of the Barron's Roundtable homed in on this paradox almost as soon as our annual confab got under way last Monday at the Harvard Club of New York. America's structural problems, including a gargantuan deficit, and the policies that perpetuate them, just might bring the country to ruin—but not before the stock market rallies another 5% or 10% or 20%, our panelists predict. That's because constructive cyclical or short-term forces, including a reviving industrial economy and rising corporate profits, could influence the direction of stocks for at least the next year or so.
In the pages ahead we've distilled these 10 market mavens' big-picture views, which include a preference for equities and hard assets at a time when the Federal Reserve is printing money like mad. We call your attention, in particular, to Bill Gross' well-reasoned explanation of why negative real interest rates—the intended result of all this money creation—are a default by another name.
After the macro comes the micro, namely Scott Black's and Abby Joseph Cohen's stock picks for the new year. Founder and boss of Boston's Delphi Management, Scott brings his considerable analytical skills to bear on eight mostly small- and mid-cap companies that generate lots of cash and impressive returns on equity, but sell for underwhelming valuations.
Abby, an estimable investment strategist and head of Goldman Sachs' Global Markets Institute, favors several big-cap blue chips recommended by Goldman's analysts that will benefit from a more robust economy. Most pay nice dividends, as well, and afford exposure to growing markets overseas.
Want the names and numbers? Please read on.
Barron's: How does the new year look to all of you? Let's start with Meryl.
Witmer: We see the economy perking up in the U.S. According to ISI Group, state income-tax and sales-tax receipts are up, so people are getting jobs and spending money. Companies are willing to spend again, and in certain industries they are adding to capacity. But that doesn't mean stocks are cheap, because stocks have moved up a lot. The market looks pretty fully valued, and may have little upside from here in the near term.
Scott, what's your view?
Black: We see a conundrum. On the one hand, the economy will do well because Congress passed an $858 billion stimulus bill. Real GDP [gross domestic product] will grow around 3.5% this year. Corporate profits as a percentage of GDP are at an all-time high, but could rise another 8.8%, as measured by S&P [Standard & Poor's 500] earnings. My concern is that the deficit is out of control. To keep the economy going, we need more fiscal stimulus. The accumulated deficit is equal to 94% of GDP. That's the highest percentage since 1946. To use a phrase that has become popular lately, we've been kicking the can down the road for too long.
Which can are we kicking?
Black: Social Security, Medicare, Medicaid—how to deal with all the entitlements. We've got to get our house in order. With this kind of debt-to-GDP ratio, the U.S. is starting to resemble a banana republic. Yet the economy will be healthy this year. Unemployment is still a problem, and people who don't have jobs tend to cut back on consumption. But the industrial economy is good. Whether you look at capacity utilization, rotary-rig counts or factory shipments, all the numbers on the industrial side are pointing up by 5%, 10%, 15%.
The S&P closed Friday [Jan. 7]. at 1271.50. I am estimating corporate earnings of about $91 for this year, up from $83.67 in 2010. The market is trading for 14 times expected earnings, below the postwar median multiple of about 16 times. It is slightly undervalued. With a dividend yield of 1.8%, the S&P could deliver a total return of between 10% and 15% for the year.
Do you agree, Oscar?
Schafer: I agree that we're kicking the can down the road, although there is a real chance President Obama will give some specifics on reducing the deficit in his State of the Union address [scheduled for Jan. 25]. The only way to get out of this situation is to grow out of it. The White House needs to deal with the deficit in a constructive way, and reach out to the business community. The companies we speak with are doing well. As for stocks, in contrast to 2008-09, when all you needed were guts and capital, this year will be a stockpicker's market. The averages will go up 5% to 10%.
Felix, what do you think?
Zulauf: There are two worlds—the industrialized world and the emerging world. The industrialized world continues to live in a fiction: that it can afford its current lifestyle by going further and further into debt. At some point, the bond markets will riot against that. The private-household sector, not only in the U.S. but in several industrialized countries, remains stretched financially and will continue to deleverage. The public sector is leveraging up, and thus will support the economy. The U.S. economy will muddle along, probably growing by 2.5% to 3% this year. Inflation isn't a problem yet in the industrialized world.
The emerging world has experienced high levels of growth, but it is entering a period of rising inflation. How emerging economies handle that inflation will be the decisive factor for the industrialized world. If they decide to fight inflation with really restrictive monetary policies, we're in trouble. If they hike interest rates only a little to restrain growth, the cycle can be extended. But that means later on, perhaps in a year or two, they will have much higher inflation and will have to crunch it. The choice is between more growth in the short term and then a crunch, or a more serious bear market now.
Which path will they choose?
Zulauf: Emerging economies will go the shallow way. They don't want to crunch it here.
Hickey: But we're looking at 8% inflation in India and Russia, and 5% in China. Will they be able to hold off much longer?
Zulauf: The decisive factor is China, which is reporting inflation of just over 5%. In reality, it's probably twice that. The Chinese aren't interested in crunching their economy. They have a mandate to create jobs. But maybe they'll hike rates two or three times this year, and U.S. stocks will have a few selloffs of 10% or more.
Let's get Bill's opinion.
Gross: The developed world is coping with the excesses of the past 20 to 30 years. The deleveraging cycle isn't just a one-to-two-year thing. The proportions of the excess, and now the attempts to deal with it, have a number of consequences. For one, growth will be slower, and inflation will be lower. In the U.S., we're seeing unacceptably high levels of unemployment—not just the published 9.4%, but 16% to 17%. The question is, can a debt crisis be solved with more debt?
In Portugal, Greece, Ireland and Spain, which lack the ability to devalue their currencies, a debt crisis can't be solved with more debt. Japan appears to have done a good job so far, because its debt is 200% to 250% of GDP, much higher than here. The U.S. has the advantage of being a reserve currency, which means it can print its way out of this situation. But that requires a willing acceptance on the part of creditors that the money it is printing is of decent value. Current interest rates, including a federal-funds rate of only 0.25%, are unacceptably low. Real [inflation-adjusted] interest rates are negative. Printing your way out of this, or kicking the can, is possible for some countries, but the solution isn't to create paper. It is to create goods and services the rest of the world wants to have.
And what are the prospects for that?
Gross: The Obama administration has failed miserably in that regard. It has focused on consumption and fiscal stimulation that will give us 4% real GDP growth in 2011. But it gives us nothing more than that. It is a sugar high that disappears quickly in 2012.
We need to focus on employment and investment in manufacturing goods and services. You don't do that by incenting businesses with tax breaks and accelerated depreciation, because they fail to observe the final demand for their products and the ability to earn an acceptable return. Cash sits on their balance sheets. You do it with massive infrastructure programs such as the construction of high-speed rail lines. China has several hundred. We need infrastructure repaired in the U.S., as well, but so far the administration doesn't seem to want to go there. It wants to placate business with tax advantages and higher after-tax profits.
It's not just the administration, but across the political spectrum. Where does that leave us?
Zulauf: All other industrialized countries, almost without exception, have focused on cutting deficits. The U.S. alone hasn't addressed the problem. If you eliminate public-sector tax revenue and spending, the U.S. economy would have grown in only two of the past 10 years. Public deficits have been supporting this economy for the past decade. The country has been suffering from under-saving and under-investment. Markets would cooperate fully if the government decided to pursue large, multiyear investment programs financed by debt. That would create a future return, and jobs.
And it would create a larger deficit.
Zulauf: Yes, but it is a different type of debt.
Hickey: It isn't debt that finances consumption.
Gabelli: When Obama became president, his No. 1 job should have been to create jobs. Today, his job No. 1 is to get himself re-elected. The Republican victories in the midterm elections in November gave clarity and confidence to a lot of business executives. They will build on that. But how does the U.S. compete when our jobs are being exported? When our education is not ranked in the top 20 in the world? The avionics industry in the U.S. dates back to the 1950s. As a country, we have to keep spending on R&D [research and development], but where should we focus our R&D spending for the next 20 years? On electric vehicles? Alternative energy? That's what the Chinese are doing.
What is your outlook for this year, Mario?
Gabelli: Beijing will engineer a soft landing, because China has structural unemployment issues and a recession would create political havoc. Europe will suck it up and continue to bail out the European Union's weaker members. In the U.S., [Federal Reserve Chairman Ben] Bernanke's quantitative easing has stimulated the stock market. When is that over, and what happens next? I don't know. Barack has moved toward the political center, which has improved confidence among executives and investors. The U.S. is OK, and Europe will muddle along. China grows 7%, 8%, 9%. That gets us to 2012, which looks better.
Gabelli: Housing is going to recover because we produced roughly 500,000 new homes last year, and demand is about 1.2 million. The price of the average new house is the same today as 20 years ago. Incrementally, the housing market shouldn't decline anymore, and the rate of change should be positive and increase. In 2011, new-car sales will be up by a million units in the U.S., to 11.5 million units. From 2010 to 2015, global production should increase by 20 million. Of that, seven million new cars will be produced in China, five million in the U.S. and the balance in the rest of the world. If Boeing (NYSE: BA - News)ever gets its Dreamliner to fly, you'll have four years of increased production. In the industrialized world, the 100% depreciation allowance will create strong demand.
Of course, all this is postulated on things that haven't happened yet, and might not. Abby?
Cohen: We are having two sets of discussions here. One is cyclical, or short term. The general perception is that 2011 will be a good year for the U.S. economy, probably the best since 2004-05. Real GDP will grow about 3.5%, even with significant headwinds. But the tailwinds are significant, too. The strength in the corporate sector started even before the recession ended. Business investment in equipment, including IT [information technology], has been robust. We have seen vigor in U.S. exports.
They were the fastest-growing segment of the economy before the financial crisis, averaging 8% to 10% per annum, and are back there now. We are selling business equipment and other high-value-added goods and services across the world.
Gabelli: Don't forget corn, wheat and beans.
Cohen: Also, the consumer is coming back. Working people are seeing their incomes grow. The savings rate has moved up to 5%-6%, and even so, consumption growth has been good. But then there's the second discussion, about structural or long-term issues. Much of the unemployment problem in the U.S. is structural, and started well before the financial crisis. You could see the educational deficit building more than 10 years ago.
How do you account, then, for the U.S. winning so many Nobel prizes in science?
Cohen: We have the best university and postgraduate system in the world. But many of our average workers are not participating in it. The percentage of the U.S. population with a four-year college degree hasn't increased in a decade. We used to be ranked No. 1. Now many countries have jumped ahead of us. When you dig a little deeper, the likelihood of a young woman having a four-year college degree has increased in the past 10 years. The likelihood of a young man having one has declined. Beginning 10 years ago, a lot of young men went directly into construction and manufacturing employment. When the recession hit, we saw a significant difference in the unemployment rate between men and women. Right now the unemployment rate for men is two percentage points higher than it is for women. There is also an enormous gap by educational level. Unemployment has skyrocketed for those who have only a high-school degree.
In the U.S., it's not just the percentage of those graduating but what they're studying. The number of students getting degrees in STEM—science, technology, engineering and math—has fallen dramatically in the past 10 to 15 years. Also, in the 10 years ended before the financial crisis, median family income in the U.S. declined 4%. Among blue-collar workers, it was down 8%.
You can't force someone to study math.
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