Midyear Investing Outlook, 2014
In recent years, companies have spent generously on dividends and share buybacks. But a resurgence in corporate spending on physical assets, such as factories, equipment and office space, has been the missing link to more robust economic growth. Such capital expenditures are part of a virtuous cycle as increasing production necessitates spending, in turn creating jobs and income growth, which then increases consumer demand, boosting corporate revenues and profits.
The time is ripe for a capital-spending recovery. With some $1.6 trillion on the books of S&P 500 firms as of year-end, cash stockpiles are enormous. Commercial and industrial lending is also picking up. And companies are nearing the point at which they can’t squeeze any more production out of existing plants and equipment. The average U.S. structure, be it a power plant, hospital or restaurant, is 22 years old. That’s close to a 50-year high, reports Bank of America Merrill Lynch. The average age of business equipment, including computers and machinery, is more than seven years old, the highest since 1995.
Buybacks lose favor
Meanwhile, spending on share buybacks, a winning strategy until recently, is now penalizing companies and investors as rising stock prices make such programs expensive. The 20% of companies with the largest number of share buybacks in relation to their respective market values outpaced the S&P by nearly nine percentage points in 2013 but lagged the index slightly in the first quarter of 2014, says BMO Capital Markets. Shareholders are voicing their preference for spending on capital equipment over buybacks, dividends and acquisitions.
Bank of America Merrill Lynch sees capital spending growing at a rate of 4.7% this year and 5.7% next year, more than double the 2.6% growth rate in 2013. Beneficiaries of a spending boom would include tech, industrial and energy companies, as well as companies that discover and process raw materials. These economy-sensitive sectors together account for more than 40% of revenues generated by S&P 500 companies.
Tilting your portfolio toward economy-sensitive stocks in general is in order as economic growth picks up, and a number of money managers favor these so-called cyclical stocks. USAA’s Toohey recommends Eaton Corp. (symbol ETN), a maker of industrial equipment. The 2012 acquisition of Cooper Industries is boosting revenues at the company’s electrical products and services unit, its biggest division. Jim Stack, of InvesTech Research, is a fan of software giant Oracle Corp. (ORCL), which has attractive growth opportunities in cloud computing and is trading at just 13 times estimated year-ahead earnings. Osterweis manager Berler likes Occidental Petroleum (OXY), a resource-rich energy company that has decades’ worth of drilling opportunities with its existing assets, as well as one of the strongest balance sheets in the industry. Investors interested in owning a broad array of industrial concerns can explore iShares U.S. Industrials (IYJ), an exchange-traded fund.
Even if all goes according to the bullish scenario, however, investors will soon realize that investing in a bull market approaching senior-citizen status is different than what they’ve grown used to. Until recently, for instance, a winning strategy for investors was simply to buy and stick with winning stocks. But a momentum-based approach is no longer working. For evidence, look no further than the recent fall of high-flying biotech and social media issues. The Nasdaq Biotechnology index has fallen 16% from its February 25 peak, and shares of social media standouts Twitter (TWTR) and LinkedIn (LNKD) have plunged 48% and 40%, respectively, from their recent peaks.
The good news is that the market’s most overpriced sectors are retreating without bringing the broader market down with them. “Bubble talk was applied broadly to the market, but really applied to only those high-flying areas,” says Liz Ann Sonders, chief investment strategist at Charles Schwab & Co. Stocks overall are still fairly valued, if no longer cheap. Based on estimated year-ahead profits, the S&P 500’s price-earnings ratio is 15—a tad below the long-term average and well below the levels of past market peaks. If the market’s hot spots can cool down on their own, “it’s possible we can wring out the excesses without a major calamity,” says Sonders.
The perils of politics
That’s unless Washington roils the markets again. Midterm election years bring political uncertainty and stock market volatility. In every midterm election year since 1962, says Sonders, the market has corrected, sometimes viciously, with average declines of 19%. But patient investors are rewarded, because 100% of the time, the market has rallied—and significantly, with average gains of 32% for the 12 months following the correction. Geopolitical upsets—especially in reaction to Russia’s activity in Ukraine—are another worry. “There may not be a fighting war, but an economic war could have an effect on the global economy,” says David Kelly, of J.P. Morgan Funds