As the midpoint for the year is upon us, it seems appropriate to review US equity market performance and, more importantly, outline what we can expect now as we enter the second half. In early March, equities appeared to be pricing in limited growth prospects, seemingly in perpetuity.

Economic and sentiment indicators pointed to a downward spiral in end demand; however, the stabilization in the data and the surge in share prices since early March have dramatically altered the market’s view of what the next few years may hold.

With stock and commodity prices and government bond yields all well off their lows, and with various valuation and sentiment measures stuck in neutral territory, we have sympathy for those who are shrugging and saying, "Now what?"

STORM BELOW THE CALM
Year-to-date through June 26, the Standard & Poor’s 500 Index gained 3.1% on a total return basis, though the story beneath the surface is much more dramatic (see chart below).

The S&P 500 Technology Index is up nearly 25%, while the S&P 500 Telecommunications Services Index slipped 3.4%. The rather uninspiring -3.7% return in the S&P 500 Financials Index masks some pretty violent moves in that sector, including a 50% decline through March 9 and subsequent 93% rally off the lows.

During the last three months, investors' appetite for risk clearly increased, as hopes were placed on an economic recovery and a pick-up in corporate spending. As such, traditionally defensive sectors like utilities and health care have lagged the market thus far this year. Between the historic sell-off and two significant rallies, the market is back to levels seen just before Warren Buffett penned his Oct. 17, 2008, op-ed piece in The New York Times suggesting investors revisit US equities as an asset class.

IMPROVED VISIBILITY
Investors are looking to the second-quarter earnings-reporting season to validate the premise that the economy is getting better. The scope and magnitude of the economic downturn has severely limited earnings visibility over the past year, leading to many surprises, often negative.

Will there be fewer negative surprises as results are released, given that economic data has stabilized? The pre-announcement season – a time before earnings when companies tend to come clean if there is going to be a big divergence from prior expectations – has been remarkably quiet thus far. Add to this a modest increase in recent weeks of bottom-up earnings estimates for the companies in the S&P 500.

Our analysis suggests that 2009 earnings estimates have stabilized and are inching higher for the first time this year. Consensus estimates, which were as low as $51.59, have risen to $52.34 during the past month (see chart below).

When looking at revision trends, the story is similar. About 50.5% of revisions over the past month have been positive, which is in line with the average of 49.2% since 2000, but well above the 21% average recorded between December and April. There has not been a significant upturn in 2010 estimates, but if the reporting season is positive, analysts will likely boost their forecasts for next year.

VALUATION MEASURES
Higher earnings should improve the market's already favorable valuation backdrop. According to many valuation measures – the price/book value, the price/sales and the price to earnings before interest, taxes, depreciation and amortization (EBITDA) ratios – US equities are significantly below their averages for the last two decades.

What's more, the relationship between normalized equity earnings yields and bond yields shows that stocks are attractively valued, even after the recent run-up in Treasury yields. We see signs that "panic" has abated. Citi Chief US Equity Strategist Tobias Levkovich says his Panic/Euphoria Model shows that sentiment may be less helpful for the market in coming months.

Recent readings have moved out of panic and into neutral territory. In our view, any future improvement in sentiment may have a less pronounced impact on price performance, particularly in the absence of sustainable fundamental improvements.

MORE BALANCED
We continue to look at equities in the context of a range-bound market over the near term. The more balanced sentiment indicators and less extreme valuation metrics suggest that near-term gains may be more measured; the next leg up may have greater participation from higher quality stocks that possess more solid fundamentals than the leaders thus far.

We believe that companies with strong balance sheets, positive free-cash-flow generation and defensible operating margins will hold up better than those that have shown sharp stock-price gains in the absence of positive or improved fundamentals. If the rally is to continue, as we think it can, it may be less likely to send recent leaders such as technology, basic materials and financial stocks much higher— unless the economic recovery far surpasses our expectations.

We also believe investors will benefit from owning companies that pay sustainable cash dividends with a portion of their free-cash flow. With many companies hesitant to take on new, costly capital expansion projects, we believe dividend payments are an increasingly valuable tool for managers to use when distributing excess cash to shareholders. In our view, dividends will continue to represent a significant portion of an investor’s total return, particularly if the range-bound market environment persists.

More

Investor Watch