Second-half outlook: Not as bad as you might think

With the Standard & Poor’s 500 reaching record highs after an eight-year bull market, the Federal Reserve Bank raising interest rates and high stock valuations, strategists must be worried about the stock market, right?

Not so much.

Despite all of the above, most strategists feel the economy is fundamentally sound and despite the market’s new heights, investors have few other places to go. “Whenever the yield on the S&P 500 has exceeded the yield on the 10-year Treasury note, the S&P has risen 18% in the next 12 months,” said Sam Stovall, chief equity strategist for CFRA. Even if the index yield is within one percentage point of the bellwether bond, stocks fare well, Mr. Stovall said.

The reason for that is relatively simple: Investors go where they get the highest returns. The 10-year T-note yields 2.18%, versus 1.9% for the S&P 500. Investors reckon they can get better returns on stocks than on bonds, despite the market’s long runup.

At 23.7 times past 12 months’ earnings, the S&P 500 isn’t cheap, but low inflation expectations and low interest rates make that valuation easier to digest, Mr. Stovall said. And, he said, the economy isn’t overheating — something that would prompt the Federal Reserve to raise interest rates more aggressively in an effort to head off inflation.

The bond market, however, is reflecting concerns that the economy is slowing. “Auto sales are shrinking, retail sales are weak, and, contrary to what the Federal Reserve is saying, there has been a slowdown in consumer spending,” said John Lonski, chief economist for Moody’s Capital Markets Research Group. “Retailing constitutes the riskiest industry group as far as default outlook a year ahead.

Housing does seem to be holding up well, Mr. Lonski said. “The big question mark is, can we keep home sales growing enough to compensate for weak auto sales? The industry has basically run out of creditworthy customers, it has flooded the market with cars coming off lease, and that’s putting downward pressure on used motor vehicle prices.”

Further weighing on the markets and the economy: legislative uncertainty. “Tax reform has not happened,” Mr. Lonski said. “We don’t know what changes there will be to depreciation rules, we don’t know whether companies might lose deductibility of interest expense — if I were a CFO, I’d be thinking that maybe I shouldn’t go ahead and expand production capability, or maybe I should hold off on hiring.”

Those worries will give investors something to ponder over the summer as Congress is on break, said Dan Suzuki, senior U.S. equity strategist at Bank of America Merrill Lynch. “We’re likely to see a correction over the summer months,” Mr. Suzuki said. “Despite that fact that we had such a great first quarter for profits, growth indicators have started to roll over, and the likelihood of fiscal stimulus and tax reform have decreased.” In particular, purchasing manager indexes have slowed in many countries, although the most recent U.S. PMI increased slightly in June, according to the Institute for Supply Management.

Despite worries about a correction, however, most analysts don’t see a full-blown bear market or a recession in the cards. Mr. Suzuki expects the S&P 500 to end the year close to its current level, even though he sees a mid-year correction. “I think that makes sense to be holding higher than normal levels of cash, given the elevated risks,” he said.

At T. Rowe Price, Robert Sharps, group chief investment officer, and Justin Thomson, chief equity investment officer, said they expected “modestly positive returns” in the second half. Absent fiscal stimulus, however, stocks could face headwinds from further tightening by the Federal Reserve, falling oil prices and tightening by the European Central Bank.

At LPL, analysts are expecting a 2017 S&P 500 Index total return forecast of 6% to 9%. As of Monday, the S&P 500’s total return for the year was 10.7%. As investors increasingly trust the economy can stand on its own without the need for monetary policy support, business fundamentals should take over as the primary market engine and corporate profits will take on increasing importance.

And what about bonds? The current Blue Chip Financial Forecast for the 10-year T-note yield at year-end is 2.7%, Mr. Lonski said. “I don’t think that’s going to happen,” he said. “My sense is that it might reach 2.35%. If it made a run to 2.5%, there would be problems for equities.” At T. Rowe Price, global fixed income portfolio manager Quentin Fitzsimmons said, “In this environment, investors may find it prudent to focus on areas such as local emerging markets debt, floating rate bank loans and strong developed world corporate debt.”