Stocks Will Outperform Bonds and Cash

US stocks in 2011 will record a third straight year of double digit percentage returns, the first time this has occurred in more than a decade, according to Robert C. Doll, Chief Equity Strategist for Fundamental Equities at BlackRock, Inc

In the new year, risk assets in general and equities in particular will draw strength from continued improvement in US economic growth—in particular, a more sustainable growth path—coupled with improved business and consumer confidence, and a less hostile capital markets attitude in Washington, D.C., according to Doll. "By the close of 2011, the S&P 500 Index will be at 1,350-plus, a target that implies that the market will appreciate at least in line with corporate earnings," Doll said. The S&P 500 Index closed out 2010 last Friday, Dec. 31, at 1,257, rising over 15% for the year.

’’Our expected gains for the equity markets for 2011 are not much different from what we expected for 2010,” he said. “What’s different for 2011 is that market risk will be more to the upside than was the case in 2010."

The possible upside factors include an acceleration in jobs gains, a surprise in real GDP, earnings exceeding expectations as occurred in 2010, and Washington D.C. beginning to address the nation’s fundamental debt and budget problems.

On the other hand, Doll’s “what can go wrong?” list includes the possibility of credit problems resurfacing (including US housing, sovereign nations, and state and local governments), commodities price increases causing profit margin pressure, inflation fears, a greater than expected rise in interest rates, undue emerging markets tightening to curb asset bubbles, and currency and capital flow concerns leading to protectionist trade wars.

Additionally, Doll indicated that the magnitude of the market return since the August 2010 lows (US stocks rose over 20% from mid August through the end of the year) means equity markets may have come too far, too quickly. "I do have a concern that the exceptionally strong returns we have seen over the last couple of months may mean that we ’borrowed’ some of 2011’s returns in late 2010," Doll said.

"The upside possibilities could lead to stock market appreciation of 10% to 20% more than we expect," Doll said. "The downside issues could result in low double-digit percentage loss."

US Real GDP Will Hit All Time High in ’11

Doll has been publishing his annual “10 Predictions” for the year ahead in the financial markets and the economy for over a decade.

In 2011 the ongoing cyclical recovery will continue, Doll believes, but economic growth will continue to proceed at a less-than-normal pace due to the structural problems that continue to face most of the developed world.

In the United States, although the recovery remains subpar, real GDP will move to new all time highs sometime during 2011’s first half, Doll said. “Real final sales will increase from around 2% to almost 4% as the impact of the government stimulus program and inventory restocking wanes,” he said. “The good news is that this kind of growth is more sustainable and therefore ‘higher quality.’

"Hitting a new high for real GDP also means, of course, that the economy will have moved into a truly expansionary mode," he said.

In this environment, the Federal Reserve is unlikely to increase interest rates in 2011. “Assuming our growth outlook is correct, the Fed is likely to keep rates at near-zero through the year, although we think it’s possible that by the end of 2011 the futures curve may begin to price an increase into the markets,” Doll said.

Unemployment Dips to 9 Percent

Job growth also will improve as 2011 progresses, with unemployment falling to around 9% from the current 9.8% rate. “We believe the removal of the Bush tax cut uncertainties and the fears of a double dip recession as well as improved confidence will lead to more hiring,” Doll said.

The likely employment trend in 2011 is historically associated with solid market performance, Doll said. “Compared with any other time, equity market returns have been most ebullient when unemployment rates have been high and falling,” he said.

Stock On Pace to Outperform Bonds, Cash

As they did in 2010, stocks will outperform both bonds and cash in 2011, Doll said.

“Stocks pulled ahead of bonds in 2010’s fourth quarter, and we expect that trend to continue in 2011,” he said. “Interest rate risk will be to the upside, given accelerating economic and job growth, the revival of business capital investment, the likelihood that bonds inflows will slow, and fading deflation fears.”

Because the recovery remains “sub par,” the Federal Reserve will likely remain accommodative, which will probably result in some further steepening of the yield curve, Doll believes. Equities are likely to take over from fixed income as the preferred asset class, both in terms of price appreciation and investor flows.

US Markets Set to Continue Their Dominance

In an outcome that surprised many, the United States was one of the world’s strongest markets, and US stocks outperformed the MSCI World Index in 2010—a trend Doll expects will be maintained in the new year. “Strong balance sheets and free cash flow income statements will likely lead to significant increases in dividends, share buybacks, merger and acquisition activity, and business reinvestment,” he said. “Companies delivering earnings with solid growth prospects will likely lead the way, as high intra-stock market correlations continue to fall.”

At the same time, differences between developed and emerging markets will be less pronounced in 2011 than before, Doll believes. “The gap between higher growth rates in the developing world and the lower ones of the developed world will likely shrink somewhat in 2011, causing continued less differentiation in equity returns.”

Predictions for 2011

Here are Doll’s predictions for 2011 with his full commentary on the key trends.

1. US growth accelerates as US Real GDP reaches a new all time high.
Not only is US growth likely to be stronger in 2011 than it was in 2010, but more importantly, the quality of growth will improve. Economic growth in 2010 was based heavily on government stimulus and inventory rebuilding. Both of these factors will be less significant in 2011 than they were in 2010, meaning final demand is going to make up the slack. In particular, we believe that real final sales will increase from around 2% to almost 4%. This sort of growth is healthier for the economy and more sustainable. Additionally, we believe that economic growth in 2011 will be supported by an increase in money growth, a steeper yield curve and easing credit conditions. Nominal gross domestic growth in the United States already reached a new all time high in 2010, and we expect real GDP growth to also reach a new high at some point during the first half of 2011. Despite this outlook, however, we would caution that growth levels will still remain below trend.

2. The US economy creates two to three million jobs in 2011 as unemployment falls to 9%.
We expect improved job growth as 2011 progresses, finally making some dent in the unemployment rate. Our prediction represents a clear acceleration over the 1 million plus number of new jobs that were created in 2010 and, in effect, would represent a doubling in the rate of jobs growth. It takes approximately 125,000 jobs per month to accommodate new entrants into the labor force and our view is growth will be noticeably higher than that, averaging 175,000 to 250,000 per month. We believe the removal of the Bush tax cut uncertainties and the fears of a double-dip recession as well as improved confidence will lead to more hiring. Leading indicators of hiring, including hours worked, productivity, initial jobless claims and profitability all point to more jobs. We note with interest that new hiring plans on the part of corporations have improved as well. Historically, equity market returns have been most ebullient when unemployment rates have been high and falling than at any other time.

3. US stocks experience a third year of double-digit percentage returns for the first time in over a decade as earnings reach a new all time high.
The last time the stock market had three annual double-digit percentage gains in a row was the late 1990s. Our view is a double-digit percentage return again for 2011 is certainly possible. We expect earnings growth to continue to be better than economic growth, stocks are reasonably inexpensive and confidence levels are improving. We are using a 1,350 target as a floor for our 2011 S&P 500 forecast, which is consistent with expected earnings gains. Our view is that the risks in 2011 are more to the upside when compared with the downside risks of 2010 meaning that, if anything, our 1,350 target may be overly conservative. Should business and consumer confidence levels continue to improve, if credit problems remain manageable and if politicians remain reasonably capital markets friendly, then we could see some valuation improvements, which could push market prices even higher. Regarding the earnings component of this prediction, operating earnings per share achieved an all time high of $91.47 for the S&P 500 in June 2007, and we believe corporate earnings will exceed that number sometime around the middle of 2011. We note that in recent months earnings revisions have again turned positive after faltering in mid 2010.

4. Stocks outperform bonds and cash
While stocks did outperform bonds and cash in 2010, it wasn’t until the fourth quarter that stocks pulled ahead of bonds. We expect that environment to continue in 2011. Assuming that stocks have any sort of positive return in 2011, they will outperform cash investments, since short-term interest rates (and cash returns) are essentially stuck at just over 0%. The bigger question is bonds, but we believe that interest rates are likely headed higher given accelerating economic and jobs growth, the revival of business capital investment, the likelihood of bond fund inflows slowing and deflation fears fading. At present, there is still a wide gap between the S&P 500 earnings yield and BAA corporate bond yields in favor of stocks, and we expect that gap to close somewhat in 2011 as stocks outperform bonds.

5. The US stock market outperforms the MSCI World Index.
Before 2010, there was a multi-year pattern in which the MSCI World Index outperformed US stocks. In a surprise to many, that streak ended last year with US stocks beating the MSCI World Index in 2010 by nearly 400 basis points. We think 2011 will mark the second year of US outperformance. Compared with the rest of the world, the United States is benefitting from more fiscal and monetary stimulus, and has a more innovative economy and better earnings growth prospects, all of which should help US stock market performance. We also expect that emerging market economies will perform well, but that the gap between emerging and developed economies is likely to narrow in 2011 (which should also help US stocks on a relative basis). In other markets, we expect Europe will continue to struggle with credit and sovereign funding issues and Japan’s secular growth problems will likely remain.

6. The US, Germany and Brazil outperform Japan, Spain and China.
2010 was a year in which geographic allocations played an important role in determining investors’ overall portfolio returns, and we think 2011 will see a continuation of this trend. From our perspective, we favor markets that have evidence of accelerating economic momentum and low levels of inflationary threats. We also prefer to avoid markets that are facing significant credit risks. As a result, we are predicting that a basket of US, German and Brazilian stocks would outperform a basket of Japanese, Spanish and Chinese stocks. As we indicated in our fifth prediction, there are a host of reasons to favor US stocks, including its improving quality and quantity of economic growth. Germany is exhibiting strength in manufacturing and exports and Brazil is benefitting from a rapidly growing middle class and solid consumer spending levels. On the other side of our equation, Japan is suffering from persistently slow growth and Spain has a troubled banking system and ongoing credit woes. Regarding China, we expect economic growth will remain strong, but that market is in the midst of a tightening cycle designed to combat inflation—an environment that does not bode especially well for market performance.

7. Commodities and emerging market currencies outperform a basket of the dollar, euro and yen.
As long as global growth is at least reasonably strong (as it was in 2010), commodities prices should appreciate in 2011. We believe that oil could top $100 per barrel at some point during the year due to better macro demand and continued inventory declines and since gold is “the only currency without debt,” gold prices are likely to move higher over the course of the year (albeit at a slower pace and more irregularly than it has over the past couple of years. Additionally, industrial commodities such as copper should benefit from continued global growth and urbanization in emerging markets. As we indicated earlier, we expect the growth differential between emerging market countries and developed markets will narrow in 2011, but we remain preferential toward emerging market currencies over a basket of the dollar, euro and yen.

8. Strong balance sheets and free cash flow lead to significant increases in dividends, share buybacks, mergers & acquisitions and business reinvestment.
Corporations in America are doing very well. Balance sheets are strong and income statements are showing high levels of free cash flow. This backdrop led to high levels of M&A activity and business reinvestment in 2010, and in the year ahead we are calling for double-digit increases in dividends, buybacks, M&A and business reinvestment. We believe the key to getting this prediction right is for business confidence to improve, signs of which became evident toward the end of 2010. In addition we would argue that unlocking the 2+ trillion dollars of cash on corporate balance sheets is a significant key to better and more sustained US GDP growth.

9. Investor flows move from bond funds to equity funds
Should the economic and market backdrop play out as we expect, we should see fixed income flows slow and equity fund flows pick up materially in 2011. This would reverse a multi-year trend in which investors have been embracing bond funds and shunning equity funds. Indeed, we began seeing this reversal happen in the fourth quarter of 2010 when equities began to noticeably outperform fixed income. Flows tend to follow prices, and we would expect that during the course of this year, we will see a noticeable slowdown in bond fund flows and the switch into equity funds. The “era of fear” that we have seen in equities in the last couple of years is in contrast to the “era of greed” we saw in the late 1990’s

10. 10. The 2012 Presidential campaign sees a plethora of Republican candidates while President Obama continues to move to the center.
Election seasons seem to grow longer every cycle, and already there appears to be a long list of potential GOP presidential candidates. While it is impossible to know exactly who will run, our view is that many will declare their intention to run for president during 2011. Meanwhile, after a very difficult election for President Obama in November of last year, his move toward the political center is likely to continue as he attempts to be more business- and capital markets friendly. It is clear that elections are decided by independents and the President needs to increase his support within the independent ranks significantly in order to have a chance for reelection.