Economic and Earnings Environment Presents Attractive Backdrop for Equities

Economic and Earnings Environment Presents Attractive Backdrop for Equities

by Bob Doll, Chief Equity Strategist, Fundamental Equities, BlackRock, Inc.

Equity markets started last week by continuing the correction of the previous week, and experienced their largest peak-to-trough selloff since August, falling 4.5%. The factors driving the downturn included sovereign debt instability in Ireland, policy tightening in China and an overall sense that markets had become overbought in the strong run-up they experienced over the previous few months. Toward the end of last week, markets staged a comeback, and ended basically flat. For the week, the Dow Jones Industrial Average advanced 0.1% to 11,203, the S&P 500 Index was unchanged at 1,199 and the Nasdaq Composite rose 0.7% to 2,518.

The Irish debt crisis has been all across the headlines lately, and the ultimate end game for how Ireland will solve its funding problems remains a wildcard. In these sorts of crisis situations, perception often determines reality. If investors become convinced that a sovereign nation will default on its debt, they will withdraw capital from that country, which in turn will cause a further escalation of borrowing costs, putting further pressure on that country’s debt in a sort of self-fulfilling downward spiral. Although the situation has quieted in recent days, and Ireland appears to have enough funding to sustain itself through the next several months, further problems on this front have the potential to rattle global financial markets.

Another issue much in the news has been the potential extension of the Bush tax cuts past the end of 2010. The bipartisan summit that was supposed to take up this issue has been postponed until after Thanksgiving, but despite the delay, we continue to believe that the most likely outcome will be a one- or two-year extension of all of the tax cuts. There is a possibility that the lame duck Congress will do nothing, but we expect a deal to be made, if for no other reason than no one wants to be blamed for enacting a de facto tax increase on January 1.

Economic data continues to show that the US recovery is continuing. The Conference Board’s Index of Leading Economic Indicators rose 0.5% in October, which met expectations and matched the increase from September. Since one year ago, that index is up 6.3%, suggesting that economic momentum might be picking up as we head into the end of the year. Additionally, initial jobless claims trends have been slowly improving, which points to the possibility of jobs creation. We have also been paying close attention to the easing in bank lending standards over the past few months as a potential sign that the economic backdrop is getting better. The Federal Reserve’s recent loan officer surveys show that standards are easing, and as we discussed in recent weeks, smaller banks are beginning to get in on the easing trend in addition to the larger national banks. Although credit conditions as a whole remain tight, the steady trend of easing should be helpful in terms of promoting jobs creation and should help bolster the economic outlook. On the whole, we believe that economic data supports the view that gross domestic product growth should improve over the coming quarters.

The corporate earnings backdrop is also a positive one. At this point, the third-quarter earnings season is essentially complete, and the results show that the most recent quarter was yet another strong one. Profits were up 6.5% over the initial consensus expectations, and more than 70% of companies that reported earnings beat expectations. This marks the sixth consecutive quarter of upside surprises over that 70% level, which is unprecedented.

At present, we believe that equity markets should continue to head unevenly higher over the next several months. Earnings expectations have been on an upward trend and the economic backdrop as a whole seems to be improving. Economic projections were weaker in the April to August period, stabilized in September and October and have since been moving higher. Our view is that global growth will continue to improve in 2011. There are a number of risks, including ongoing sovereign debt issues, escalating inflation in China and the potential breakdown in global policy coordination, but our baseline scenario is for a continued cyclical recovery. For stocks, this should present a supportive backdrop, and while we are likely to continue to see additional price pullbacks, we believe they should be viewed as part of a consolidation process in a market that is headed higher.