The first half of 2011 is now complete and it certainly had its share of twists and turns.    The first quarter was strong.  In fact, the 5.4% increase in the S&P 500 was the largest first quarter gain since 1998.  The second quarter was also strong (yes, strong) as the S&P 500 declined 0.4%.

How can we consider a decline a strong showing?  Well, the answer lies in the context.

Entering the second quarter, the S&P 500 had risen 27% over the preceding seven-month period -- a move that coincided with Federal Reserve Chairman Bernanke hinting last August at the likelihood of further asset purchases and, separately, robust corporate earnings growth.

After a move like that, it was natural to think the equity market would experience a profit-taking setback in the second quarter.  However, if you add in the disruption of an epic earthquake and tsunami in Japan, a spike in gas prices to $4.00 per gallon, signs of a slowdown in China, a resurgent debt crisis in Greece, an escalation of military acts in Libya, growing political rancor over raising the debt ceiling and cutting the budget deficit in the U.S., the recognition QE2 would be ending on June 30, and signs of renewed softness in the U.S. economy, there is ample reason to consider a 0.4% decline for the second quarter a strong showing.

There is still a lot of uncertainty out there and we are on record saying the equity market could go into a summer funk in a similar manner to last year when it was very choppy through August with a prevailing negative bias.  We have added, too, that the summer months could see some irrational thinking that drives some emotional selling, which then leads to some common-sense investment opportunities.

So, then, why is our market outlook unchanged?  Because it is based on long-term value considerations and because the relative value argument for the equity market is still valid.  Actually, it got even better in the second quarter for long-term investors with the trailing twelve month earnings yield on the S&P 500 increasing from 6.38% to 6.96%.

Below we provide a snapshot of our thinking at this time for the key drivers of our market view.

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Monetary Policy

Equity Market Gauge: Bullish

    In Brief:

• The target range for the federal funds rate has remained at 0.00% to 0.25% since December 2008.
• The Federal Open Market Committee (FOMC) anticipates that economic conditions are likely to warrant exceptionally low levels for the federal funds rate for an extended period.

    Key Factors:

• The FOMC will complete its $600 bln Treasury purchase program by the end of June.
• Upon completion of the Treasury purchase program in June, the Federal Reserve will reinvest the principal of maturing agency securities in Treasuries to keep its balance sheet constant.
• Fed Chairman Bernanke believes the policy in force today will ultimately pave the way for a strengthening in the dollar.
• The inflationary effects of rising commodity prices are deemed to be transitory
• The monetary policy vote at the June meeting was unanimous.
• When pressed on the possibility of QE3, the Fed Chairman was rightfully non-committal on the issue, although he did add that conditions today are different from what they were in August 2010 when he floated the idea of asset purchases.  In particular, he said the Fed was not meeting both sides of its dual mandate then in that inflation was low and falling and employment growth was weaker than it is today.
• The FOMC updated its central tendency projections at its June meeting as follows:

    The Big Picture:

• The overriding message from the directive and the press conference is that the Fed will remain highly accommodative since it is not satisfied yet that it has done enough to achieve its dual mandate. Against a backdrop of low interest rates and strong earnings growth, that stance is supportive for risk assets -- and equities in particular.  The Fed Chairman's demeanor at the June press conference struck us as being less certain than the April press conference.  That is probably natural by default seeing how the FOMC had to own up to the economic recovery unfolding more slowly than previously expected and that the Fed does not have a precise read on why the slow pace of economic growth is persisting.  At the same time, it doesn't provide any closure for market participants to hear the Fed is in the same position as everyone else of waiting to see what the data bring to make their next move.  Our thinking is that market participants, in general, are dissatisfied with the thought that they will be handcuffed by the economic calendar for an extended period of time.

    Risks

•  Policy remains too easy for too long and inflation expectations become unhinged.
•  Fed risks fanning inflation expectations by keeping rates at the zero bound while other central banks raise rates.
• Countries pegged to the dollar are importing our monetary policy and risk fueling inflation pressures that destabilize their economy.
• Interest rate differentials could lead to capital controls that impede global trade.

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Fiscal Policy

Equity Market Gauge: Neutral

    In Brief:

• If the proposals contained in the President's budget for 2012 were enacted, the Congressional Budget Office estimates the federal government would record deficits of $1.4 tln in 2011 and $1.2 tln in 2012.  Those estimates translate to 9.5% and 7.4% of GDP, respectively, versus the deficit that totaled 8.9% of GDP in 2010.
• The U.S. effectively hit its $14.3 tln debt limit on May 16.  It is essential for the debt limit to be raised to avoid a technical default that would have negative and systemic implications for the global economy.   

    Key Factors:

• With no agreement yet to raise the debt limit, the Treasury is now in a position where it has to draw down its cash reserve account to help pay its bills and, following depletion of its reserve account, would have to consider cutting support to states or tapping federal pension plans for emergency funding.
• Standard & Poor's cut its rating outlook for the U.S. to negative from stable, citing concerns about the resolve of policymakers to address the budget challenges by 2013? Moody's says it could put U.S. government on review for downgrade if progress isn't made soon on raising the debt limit.
• As of June 17, 90% of tax benefits ($259.9 bln), 77% of Contracts, Grants and Loans ($210.4 bln), and 82% of Entitlements ($184.6 bln) have been paid out as part of the $787 bln American Recovery and Reinvestment Act of 2009
• An $858 bln tax plan compromise was reached at the end of December 2010, the main provisions of which included a two-year extension of the lower tax rates enacted under President Bush, an extension of unemployment benefits, and a surprising cut in the payroll tax for all workers in 2011.
• In the wake of disappointing employment report for May, political discussions are increasing on the need to enact new measures that will promote increased hiring activity.  President Obama reportedly is considering a cut in employer payroll taxes and extending the one-year employee payroll tax cut agreed to in December 2010.
• GOP leaders walked out of budget deficit negotiations, saying an impasse had been reached given Democrats' insistence that tax increases be included as part of any plan to cut the deficit -- this move will likely not sit well with ratings agencies and it raises concerns a compromise may not be reached before the August 2 deadline for raising the debt ceiling. 

    The Big Picture:

• We have a big deficit problem but everyone already knows that. President Obama has acknowledged it; Congressional leaders have acknowledged it; Federal Reserve Chairman Ben Bernanke has acknowledged it; Treasury Secretary Geithner has acknowledged it; the IMF has acknowledged it; the G20 has acknowledged it; and anyone reading the news has been made aware of it. The rub of course is that no one has come up with an agreeable solution. Finally, some plans are being presented where the blueprint for cutting the deficit over the long-term is couched in terms of trillions of dollars and not billions of dollars, and where the need to reform entitlement programs is entering the conversation. Still, politicians on both sides of the aisle are muddying the outlook with the same denunciations of the other party's plan that make a compromise seem unlikely at this point.   

    Risks:

• Congress fails to agree to raise debt ceiling -- a low probability, very high risk scenario.
• Failure to reach credible compromise to cut long-term deficit risks inviting a downgrade of the U.S. AAA credit rating, which would lead to a higher cost of borrowing.   
• Budget shortfalls at local, state, and federal level raise the specter of major spending cutbacks and higher taxes that can adversely affect economic growth.
• Potential for class warfare (middle class/poor vs. rich), age warfare (young vs. old), and worker warfare (private vs. public) builds with need for fiscal reform.

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 Economic Growth

Equity Market Gauge: Neutral

    In Brief:

• The third estimate showed real GDP increased at an annual rate of 1.9% in the first quarter of 2011 versus 3.1% in the fourth quarter of 2010.
• Real final sales of domestic product, which excludes the change in inventories, increased 0.6% in the first quarter versus 6.7% in the fourth quarter.  Final sales increase is lowest since Q3 2009.
• The Federal Reserve has said the weakness in Q1 GDP appears to be transitory.
• Our Q2 GDP growth forecast upped to 2.2% from 2.0% on stronger-than-expected durable inventory levels.

    Key Factors:

• Rising energy prices, and specifically gas prices, are imposing an added tax on consumers.
• The weakening dollar is enhancing the export competitiveness of U.S. multinationals while at the same time making it more expensive to import goods.
• Higher input costs are compelling some companies to raise prices to offset commodity cost inflation.
• Residential fixed investment remains weak and so does the housing market and home prices in general.  Case-Shiller Index for April showed first month-to-month increase in home prices for the 10-city and 20-city composites in eight months.  Year-over-year, prices for those composites are down 3.1% and 4.0%, respectively.
• Government spending is contracting at all levels and is shrinking the labor pool of government workers.
• The manufacturing sector has been a bright spot, although recent readings for regional surveys have shown signs of deceleration.
• Weekly initial claims remain above our "Recovery Zone" of 410,000, suggesting nonfarm payrolls will be challenged to grow in excess of 100,000 and making it difficult to bring down the unemployment rate.

    The Big Picture:

• Economic growth in the U.S. clearly decelerated in the first quarter, yet we think that will be a temporary happening.  Signs of continued strength in the manufacturing sector combined with strong corporate earnings growth, increased business lending, and improved hiring activity should act as positive turning points for the U.S. economy as the remainder of 2011 unfolds.  Notwithstanding the weakness in the first quarter, our forecast calls for 2.6% real GDP growth in 2011.

    Risks:

• Consensus growth forecasts prove to be too high
• A spike in interest rates that is fed by factors other than a pickup in economic growth would threaten to choke off loan demand and economic activity.
• Higher oil/gas prices crimp discretionary spending in a material way.
• Inflation expectations become unhinged, forcing the FOMC to raise rates before a labor market recovery has been solidified.
• Real average hourly earnings continue to decline, weighing on spending activity, capital investment decisions, and standards of living.
• Geopolitical crisis that delays capital spending decisions.

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Inflation

Equity Market Gauge: Bullish

    In Brief:

• Over the last 12 months, the Consumer Price Index increased 3.2% (from 2.7%) before seasonal adjustment -- the highest figure since October 2008.  Excluding food and energy, core CPI is up 1.3% (from 1.2%).
• Over the last 12 months, the Producer Price Index has increased 7.3% (from 6.8%) before seasonal adjustment.  This is the largest increase since an 8.8% increase in September 2008.  Excluding food and energy, core PPI is up 2.1% (unchanged from April).
• Over the last 12 months through May, the PCE Price Index has increased 2.5% (from prior 2.2%).  Core PCE, which is the Fed's preferred inflation gauge, is up 1.2% (from prior 1.0%), below the Fed's central tendency projection range of 1.5% to 1.8% for 2011.

    Key Factors:

• Rising food and energy prices have captured everyone's attention, but prices for all commodities have risen sharply.
• It is the FOMC's expectation that recent increases in the prices of energy and other commodities will be transitory.
• With the excess supply in the labor market, there are no signs of wage inflation and/or wage pressures.
• 5-year, 5-year forward breakeven rates have dropped 26 bps since mid-April to 2.74%, indicating the market's inflation expectations have eased considerably of late with softening economic data and the pullback in oil prices.

    The Big Picture:

• Understandably, there has been a lot of attention paid to the spike in commodity prices.  That spike has been somewhat slow to pass through to consumers, as businesses have been reluctant to risk losing market share by raising prices to combat higher input costs.  We are starting to hear more companies suggest they will enact price increases, but when the consumer's push comes to shove, we will see if these companies are resolute with their price hike decisions.  Our sense is that push will eventually come to shove, too, since the labor market recovery isn't happening quickly enough to drive up wages in material fashion to deal with higher prices.  If that remains the case, demand will lag at the higher price points and lower prices should follow from either: (a) demand destruction or (b) companies cutting prices to maintain market share.  Without wage inflation, though, corporate profit margins should hold up reasonably well.

    Risks:

• Inflation expectations become unhinged and the FOMC is forced to raise interest rates.
• Wage inflation pressures escalate and squeeze corporate profit margins.
• High food and gas prices detract from discretionary spending and also create social unrest, particularly in developing markets.
• Weakening dollar leads to higher cost of imported goods and creates added inflation problems for countries pegged to the dollar, which leaves them in the position of importing U.S. monetary policy.

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Earnings Growth

Equity Market Gauge: Bullish

    In Brief:

• Earnings growth has been incredibly strong.  Dating back to Q1 2010, operating earnings for the current S&P 500 constituents have increased 54%, 41%, 30%, 30% and 19% respectively, according to FactSet.
• Led by the materials (+49%) and energy (+38%) sectors, the estimated S&P 500 earnings growth rate for Q2 2011 is 14%.  Revenues are projected to be up 11%.
• According to FactSet, the forward twelve-month consensus earnings estimate has risen from $95.89 at the start of the year to $106.25 today.

    Key Factors:

• Better-than-expected first quarter earnings were driven by a pickup in revenue growth and continued cost-cutting activities.  The combination mitigated margin pressures stemming from rising input costs.
• Companies have called attention to rising commodity cost pressures, but in general have retained a positive earnings outlook, citing improved demand in the U.S. and continued growth in emerging markets.
• The impact of the tsunami in northern Japan has impacted specific industries (e.g. technology and auto), but the general impression is that any slowdown or supply chain disruption related to the tsunami will be short-lived.

    The Big Picture:

• The strength in earnings and generally reassuring guidance have acted as primary sources of support for the equity market in the face of concerns about Europe's debt crisis, unrest in the MENA region, the tsunami in Japan, and China's efforts to slow its economy.  A list of concerns could continue, but thus far, earnings from corporate America continue to suggest there is more bark in the media about these concerns than there is actual bite in them.  That dynamic could change, but with consensus earnings estimates holding up and companies remaining confident in their outlook, the risk premium in equities looks like a marker of unsubstantiated fears about economic and earnings growth prospects that is creating a long-term buying opportunity.

    Risks:

•  A period of stagflation that erodes profit margins.
•  A rising interest rate environment that chokes end demand.
• A sharp downturn in U.S. economic activity that sparks another jump in layoffs which, in turn, negatively impacts spending behavior due to reduced incomes.
• A terrorist incident or geopolitical conflict that creates a huge air of uncertainty that forestalls spending activity.
• Companies being too optimistic with their forecasts
• Earnings surprise quality erodes with buybacks, lower tax rates making the difference

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Valuation

Equity Market Gauge:  Bullish

    In Brief:

• At current prices, the S&P 500 trades at 12.4x forward twelve-month estimates.

    Key Factors:

• The historical P/E multiple for the market is 15x -- and that is with an inflation rate north of 3% and the 10-year Treasury yield at 6.00%. Today, the S&P 500 trades at 14.4x ttm earnings with core inflation rates between 1% and 2% and the 10-year Treasury yield at 3.15%.   
• There is a lot of room for interest rates to rise simply to catch up with the current P/E. The current P/E essentially assumes much higher interest rates than currently exist.  This provides downside cushion and reduces the current risk in the stock market.
• The forward twelve-month consensus earnings estimate could be cut by 30% and the earnings yield for the S&P 500, based on current prices, would still be 249 basis points above the current 10-year Treasury yield. 

    The Big Picture:

• The stock market theme we have been emphasizing for some time is one of relative value. Quite simply, U.S. stocks present a value-based investment opportunity vis-a-vis U.S. Treasuries and many other investment choices.  That is not to say the U.S. stock market will not go into a summer funk. It might. The economic outlook remains murky, and there are plenty of legitimate areas of concern.  Nonetheless, the long-term relative value orientation of stocks is evident in the wide spread between the forward twelve-month earnings yield for the S&P 500 and the yield on the 10-year Treasury note.  That spread, or risk premium, is 491 basis points.  The 20-year average is 123 bps while the average risk premium seen in the 2003-2007 bull market was 185 basis points.

    Risks:

• Momentum investing leads to excess multiple expansion that heightens downside risk in the event of a spike in interest rates.
• Earnings growth turns negative or is expected to turn negative in future.
  
   

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Exogenous

Equity Market Gauge: Bearish

    In Brief:

• Unrest in the MENA region; civil war in Libya; potential for Saudi Arabia to experience political revolts that disrupt oil production.
• European sovereign debt crisis
• China tightening monetary policy in bid to slow growth and curtail inflation pressures.
• Deadline is approaching on need to raise U.S. debt limit and political gamesmanship is creating unneeded uncertainty.
• Political resolve to address long-term budget deficit is in question along with validity of U.S. AAA credit rating.
• Possible terrorist reprisals after Osama bin Laden's death.
• Impending arrival of Atlantic hurricane season poses threat to oil/gas supplies in U.S.  (NOAA is forecasting above average Atlantic hurricane season for 2011, with 12-18 named storms, 6-10 hurricanes, and 3-6 major hurricanes)

    The Big Picture:

• This "exogenous" category could just as easily be labeled "things that keep market participants up at night."  By definition then, items in this category have a bearish orientation. Any one of them -- or all of them combined -- as well as those exogenous forces not yet known have potential to create a material dislocation in capital markets.  These same forces, however, can also create attractive buying opportunities if concerns surrounding them ultimately prove to be overdone.  In general, though, the uncertainty generated by exogenous items acts as a limiting factor for the equity market, albeit one that is a less limiting factor when earnings growth is still rising.

--Patrick J. O'Hare, Briefing.com

Patrick J. O'Hare is the Chief Market Analyst for Briefing Research, Briefing.com's institutional research service. To request a free trial please email researchsales@briefing.com.