2012 Begins With A Bang


Helped by stronger-than-expected economic numbers and increasingly accommodative central banks, along with sharply lower government bond yields in Europe, stocks have rallied around the globe. While the Dow Industrials enjoyed their best January in 15 years, the U.S. has been a relative laggard so far this year. Reflecting the addition of two new names, our stock-market exposure is being increased slightly. Our buy lists now have 87.6% to 90.1% in stocks, with the remainder in a short-term bond fund.

Possible catalysts

December-quarter results have been mixed, with a lower-than-normal 61% of S&P 500 companies exceeding consensus profit estimates. But year-ahead expectations are largely intact, with consensus estimates projecting earnings for the S&P 500 Index will be up 9% in 2012 — down from the 10% expected in early January.

Profits for the S&P 500 Index have increased 125% since the end of 2009, the fastest expansion in a quarter century, according to Bloomberg. Consensus estimates project S&P 500 Index earnings per share will reach a record $106 for 2012 and $119 for 2013, according to Thomson Reuters. Yet the S&P 500 Index trades at less than 14 times trailing earnings, well below the five-decade norm of 16.

What will it take for stocks to gain fans and regain past valuations? We see at least three possible catalysts:

Investors could gain confidence that bond yields are likely to remain near current levels. Stocks are very cheap relative to today's bond yields. The Federal Reserve has already pledged to keep short-term rates near 0% through 2014, but investors remain unconvinced that long-term bond yields will remain low. Still, if 10-year Treasury bond yields remain near 2% as the U.S. economy gains momentum, P/E ratios could jump.

Companies could maintain robust dividend growth. The one theme attracting equity investors is income. The average yield of S&P 500 dividend payers has moved above 10-year Treasury yields, partly because of brisk dividend growth. But the percentage of earnings being paid out in dividends is near an all-time low at roughly 28%, so companies have ample scope to lift dividends sharply higher. Mid-January through February is typically the busiest time for dividend increases.

Takeover activity could heat up. With stock valuations relatively low, interest rates very low, and corporate cash hoards near all-time highs, many expect a surge in deal-making activity. But merger-and-acquisition activity slowed sharply in the second half of 2011, and Dealogic says global M&A activity in January was the lowest for any month since 2004.

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