Morgan Stanley's Midyear Advice to Clients: Lean Toward Stocks, Cash

Keep your eyes on the second half, when the market will demand improved economic growth and earnings to keep rising.

Adam Parker is the chief U.S. equity strategist for Morgan Stanley.

You started out 2013 with a cautious market view, but then became more bullish. Why?

To get the market right, you have to get earnings growth right — but you have to get the price-earnings ratio right as well. We raised our view of the market mul­tiple a couple of months back. We think that earnings growth will slowly improve and that the Federal Reserve's accommodative monetary policy will continue, with the effect of keeping bond yields low and stocks more attractive. That will elevate the P/E. Our forecast went from a market P/E of 13 times estimated earnings to 14.5 times. We think stocks in Standard & Poor's 500-stock index will earn $110 a share in 2013, so our target went from 1430 to 1600.

The market has exceeded your target. What now?

Our call has been that the market will do fine — we call it a hall pass — as long as growth is better later in the year and the Fed continues to be accommodative. But the rubber hits the road in the second half. Either we do get improvement in economic growth and earnings, or the improvement turns out to be more muted than people think, which could cause a market sell-off. The risk is on the downside.

What's your take on the economy?

The call from our economics team is for a better economy in the second half as the government resolves its fiscal issues. The risk is that companies don't hire people or spend to build factories. Managers need to believe in sustained demand for their products, but CEO confidence is not very high.

Should investors pocket their gains and go home?

If the S&P rises well above 1600 and we're not confident that earnings will improve, we'll tell people to sell. We're not making that call now; we're still constructive.

Is it too late for investors to get in?

Our advice to clients is to be overweighted in stocks and cash. In our three- to five-year view, we're more sanguine about stocks and more worried about bonds. The six-month view is a tougher call. You could have a hiccup in stocks. It's all about your holding period.

Where do you see opportunity?

Within the U.S. stock market, we see three interesting themes. We like U.S. companies that have exposure to growth in China. Right now, sentiment about China is low. But the growth rate there is much higher than in the economies in developed countries, even if it's weak versus expectations. Industrials and tech get a decent percentage of earnings from China. Two such companies are United Technologies (symbol UTX) and Agilent Technologies (A).

What's the second theme?

Dividends and dividend growth. We think bond yields will stay low and there will continue to be a huge demand for income from stocks. The average yield on stocks in the S&P is above the yield on ten-year Treasuries. More management teams are paying themselves with stock, which allows them to benefit from dividends, instead of with stock options, which emphasize capital appreciation. Corporate payout ratios (the percentage of earnings paid out in dividends) are low. The long-term average is about half. Now it's just over one-third, so companies have room to increase dividends. A good example of this theme is Philip Morris International (PM).

And the third theme?

We like large, high-quality companies. Large-company stocks are cheaper than stocks of small-to-medium-size companies and have better balance sheets. Earnings estimates for small-company stocks are optimistic. If the economy doesn't improve as much as people think it will, small caps will miss earnings estimates more often than large caps will. We also think that stock pickers don't need to gamble on risky stocks. Stick with higher-quality names, such as Capital One Financial (COF), Cardinal Health (CAH) and Costco Wholesale (COST), and you'll do fine.

What industries do you favor?

We're most bullish on health care. Spending on research and development has been poor for a long time, but it's improving now — we're starting to cure some diseases. That will reward biotech and pharmaceutical stocks, such as Pfizer (PFE). We also like industrials, such as Honeywell International (HON), which are benefiting as the economy moves into daylight. Lastly, we like technology. Security-software firms, such as Symantec (SYMC), are the least economically sensitive because security is something that chief technology officers are most committed to paying for.

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