Europe’s financial woes must be resolved. But additional 2010 gains are still possible. By Andrew Tanzer, Senior Associate Editor May 6, 2010 The economy is perking up. Consumers are opening their wallets. Durable-goods orders are increasing, a sign that executives and other businesspeople are becoming more confident about the future. After a collapse in capital spending, companies are once again investing in software, technology and equipment. Exports are rising. Even housing prices may have stabilized.But now panic in Europe is sparking turmoil in stock markets. Greece is on the brink of bankruptcy, and the action in bond and currency markets indicates growing fear that the sickness will spread. Everywhere, it seems, investors’ appetite for risk has taken a sudden hit, which is what drives down prices of stocks and other risky assets. The Dow Jones industrial average, after being down as much as 998.50 points during the day, closed May 6 at 10520.32, off 347.80 points, or 3.2%. The big question now is whether Europe, in concert with the International Monetary Fund, can fence off the contagion. Shocks from Europe could unhinge the global economic recovery. So an investor must weigh the two opposing forces of a sovereign (or government) credit crisis spiraling out of control in Europe and the economic rebound in the U.S. and around the world. At home, there has been an unmistakably V-shaped recovery in corporate earnings. From globetrotters such as 3M and IBM to domestically oriented operators such as Chipotle Mexican Grill and railroad Union Pacific, companies are reporting a surge in profits this year, in contrast to the dark ages of the first half of 2009. Analysts are hurriedly ratcheting up their forecasts. By 2011, they say, earnings for companies in Standard & Poor’s 500-stock index will return to the record level set in the pre-crash year of 2006. My, that was fast. Advertisement Given the depth of the recession, which probably ended in the summer of 2009, the current recovery is anemic by historical standards. Unemployment remains stubbornly elevated, and small businesses are struggling to obtain bank credit. David Bianco, chief U.S. stock strategist for Bank of America Merrill Lynch, says there’s a good reason for this apparent anomaly: The complexion of the S&P 500 index is increasingly deviating from that of the domestic economy. The home economy is driven by consumption, while companies connected to business spending, energy, materials and sales overseas -- all of which respond to global economic growth -- dominate the index. Bianco foresees profits generated from abroad, which represent 40% of the total now, rising to 50% or more within five years. More gains ahead? So where does this leave investors? Even after the recent sharp market drops, the S&P 500 is still up 67% from its March 2009 low. It’s fair to ask whether the bull has any more room to run. That will depend on how the turmoil in Europe plays out. But a combination of rock-bottom interest rates, abundant cash, strengthening earnings and lower stock prices (the S&P 500 has fallen 7.3% since April 23) could still produce additional gains of 10% by the end of 2010. Advertisement Many of the experts we spoke with are pessimistic about the stock market’s longer-term prospects, however. They fret about the implications of higher taxes, more regulation, lower long-term economic growth, stubbornly high unemployment and, perhaps most of all, the appalling condition of our public finances and the lamentable state of politics in our nation’s capital. Rich Howard, co-manager of Prospector Capital Appreciation, says he’s bullish for the short term but bearish over the long haul. Alan Gayle, director of asset allocation for RidgeWorth Investments, calls himself a “nervous bull.” Ed Maran, co-manager or Thornburg Value, worries about higher inflation and interest rates down the road stemming from the deep fiscal hole we’re digging. But he, too, is a short-term optimist. “Investors would be well served not to worry for one year,” he says. All of this does sound a bit ominous. As always, before taking the plunge into stocks, ponder the risks: the still-fragile housing market, the health of the nation’s banks and the troubles overseas. Four years after the bubble burst, housing is still an ugly sight. Some 3.5 million homes sit vacant -- double the normal number. Sales of distressed homes, which weigh on housing prices, represent 35% of total house sales. Tom Zimmerman, a specialist in asset-backed securities at UBS, projects five million more defaults and two million more delinquencies over the next four years (10% of mortgages are currently seriously delinquent). Even with the rebound in stocks and some other financial assets, Americans are struggling to boost savings (the savings rate was still an anemic 3% in the first quarter of 2010) while cutting debt. This is no easy task in an environment of high unemployment and weak income growth. Merrill Lynch economist Ethan Harris thinks these and other factors will translate into subdued consumer spending for five years. Advertisement What about banking, the new whipping boy? Last year, the U.S. recorded its steepest decline in lending since World War II (despite the surge in government lending), and bank credit continued to contract in the first quarter of 2010. Some large banks are back on their feet, and if you’re a big corporation you have ready access to capital in the bond market. But if you read between the lines, the balance sheets of many local and regional banks are still grim. As a result, many banks remain unwilling to extend credit to small and midsize businesses. Finally, let’s not forget the potential for a lingering threat from weakness in European economies and the risk of the euro currency unraveling. Greece is basically insolvent, but it may just be the canary in the coalmine. The gaps -- and tensions -- among the 16 economies lashed to a common currency are becoming more apparent. “You can’t have one central bank and 16 treasuries,” says John Makin, economist at the American Enterprise Institute. What to do now? So with eyes wide open, let’s look at some investment strategies for this market. One approach for picking stocks over the next year is to focus on shifts in the economy and earnings. The past year’s market celebrated survival: Shares of small companies and low-quality firms soared after the world didn’t come to an end. So far this year, financials and stocks in cyclical industries have led the advance, driven by an economic rebound and easy earnings comparisons with the bombed-out levels of the first half of 2009. Investing in companies with sustainable revenue and earnings growth may be the next theme. Overall, profit growth will decelerate in the second half of this year, and earnings growth in 2011 will be modest compared with 2010, a big turnaround year. Advertisement One good place to start the search is with U.S. multinational corporations, particularly those with strong positions in fast-growing developing economies. Larry Adam, chief investment strategist for Deutsche Bank Private Wealth Management, says that the current economic recovery marks the first in which emerging nations were the locomotive that pulled the world out of recession. Over the next five years, Deutsche Bank projects, emerging markets will account for 50% to 75% of global economic growth. Merrill Lynch’s Bianco thinks one sweet spot today is “global cyclicals” -- sectors such as technology, industrials, energy and materials that are boosted by higher global growth. Bianco has a particular soft spot for U.S. companies that are replicating their business models abroad. He says that even big, mature companies can accelerate growth by raising low-cost capital at home and investing it overseas in high-growth developing countries. Emerging-markets beneficiaries Mark Phelps, chief executive of asset manager W.P. Stewart, looks for U.S. companies with mature domestic businesses that are generating abundant cash flows, which can be redeployed in faster-growing markets, such as China. For instance, KFC and Pizza Hut, both franchises of Yum Brands (symbol YUM), are stale concepts at home but are booming in China, where Yum books 38%of its profits. Phelps, who likes both YUM and Pepsico (PEP), says that wages and retail sales in China are expanding by 15% a year. Similarly, Jordan Opportunity Fund’s Jerry Jordan has gravitated to high-quality U.S. blue chips that have the stamina to boost earnings for many years. For instance, he likes Coca-Cola (KO), another company with unexciting growth prospects in the U.S. but bubbling opportunities abroad, where it already generates three-fourths of its profits. Jordan has also warmed to media companies, such as News Corp. (NWSA), Walt Disney (DIS) and Viacom (VIA). He thinks they all have excellent opportunities for long-term growth around the globe, in part because of the proliferation of new venues for their content, such as Apple’s iPad. From a longer-term perspective, let’s not overlook demand for commodities arising from the global economic recovery. Fred Sturm, the veteran manager of Ivy Global Natural Resources Fund, says that capital investment in large-scale mining and energy projects collapsed during the recession. So new supply will be constrained while demand rebounds. For instance, car sales in China, up more than 50% this year, have surged ahead of U.S. sales. “Never before has the Chinese auto market needed this much fuel or the iron ore to make the cars,” says Sturm. The Toronto-based manager foresees prices of many key commodities, such as oil and iron ore, rising 50% to 100% over the next five years, a period during which the world’s population will grow by 350 million. As a result, Sturm favors natural-resources stocks, such as Occidental Petroleum (OXY), mining giant Rio Tinto (RTP) and Potash Corp. of Saskatchewan (POT). If you prefer to invest through mutual funds, Fidelity Contrafund (FCNTX) and Vanguard Dividend Growth (VDIGX) have large allocations to multinational corporations. If you feel more like sitting on the fence, consider some funds, such as FPA Crescent (FPACX) and Hussman Strategic Growth (HSGFX), that have the ability to own stocks as well as sell them short to profit from falling share prices.