It's been a volatile ride punctuated by some setbacks along the way. But over the past two years, investors have seen U.S. equities advance with incredible strength. In fact, U.S. stock market averages have more than doubled since their nadir in March 2009. Despite these gains—or perhaps because of them—many investors remain wary about the prospects for stocks. Many are gun-shy after witnessing two recessions and the two worst stock routs of their lives in just the past 10 years. Others sat and watched the current rally of the past two years and fear they may have missed the buying opportunity. In either case, investors are worried and they are seeking direction.
This sense of unease should not be surprising. The list of "what could go wrong," seems longer than ever. The world is still feeling the effects of the 2008-2009 credit crisis, evidenced by ongoing sovereign debt issues in Europe. The global economy is in better shape than it was a couple of years ago, but can hardly be called robust. U.S. unemployment remains strikingly high and some areas of the economy—such as the housing market—have yet to even start to recover. Many investors are also becoming increasingly concerned about inflation, particularly given U.S. fiscal imbalances. Indeed, real inflationary problems are starting to crop up in some areas of the world.
Exacerbating these concerns are the rising oil and energy prices.
And if all that were not enough, 2011 has seen a resurgence of geopolitical instability, which always has the potential to cause market disruptions.
Despite all of these risks, however, we believe the long-term positives for stocks outweigh the negatives, and we recommend investors with longer investment time horizons establish or maintain overweight positions in stocks (particularly U.S. stocks) for their portfolios.
Our arguments for why investors should take a fresh look at U.S. stocks is perhaps best expressed in the 10 predictions we established at the beginning of the year. For over a decade, we have published (and at year's end, scored) a series of economic and market forecasts. The annual predictions have been an effective tool in helping financial advisors and their clients understand our views on investment opportunities and portfolio positioning. [Editor's Note: A full analysis of the 10 predictions for 2011 can be found at blackrock.com; look for "What's Ahead in 2011."]
Three of our predictions clearly made the case for an investment in U.S. stocks and appear to remain well on track as we approach mid-year. The following is a brief overview.
It hasn't been since the boom years of the late 1990s that U.S. stocks managed three consecutive years of double-digit gains. But we believe such an outcome is possible this year. Our broad case for U.S. stocks is based in part on the following macroeconomic observations: First, the U.S. economy is in the process of transitioning from a government stimulus-led recovery to a healthier, self-sustaining expansion. Second, core inflation in the U.S. should remain contained—the overall economy is operating at a below-capacity rate and unless energy prices exhibit a sharper and longer-term move higher, they should not noticeably spill over into core inflation readings. And third, the Federal Reserve has made it clear that short-term interest rates will remain near 0% for the time being.
These three macro factors have been in place for some time and have made for a sweet spot of sorts for stocks. We believe this backdrop, combined with strong corporate earnings growth and attractive stock valuations, should result in a double-digit gain for 2011 and continued good performance beyond this year.
OUTPACING BONDS AND CASH
So what about areas of competition for stocks—chiefly bonds and cash? To us, the stocks versus-cash-argument is pretty straightforward.
Short-term interest rates have been stuck at close to zero for some time, and that doesn't appear likely to change any time soon. In such an environment, cash investments are returning only a fraction over 0%, so any positive return in the stock market would mean stocks beat cash.
The question of stocks-versus-bonds is a bit trickier, but we've been right on this one so far in 2011, and our expectation is that stocks should win out over bonds over a multi-year time horizon. Bond yields remain low by historical standards and we believe they will head higher (and bond prices lower) as economic and job growth accelerate, business capital investment revives, investor flows into bond funds slow or reverse and deflation fears fade. Although there are certainly attractive areas of the bond market, from a broad perspective we believe stocks are a better long-term bet.
The third match-up on the card is U.S. stocks versus international stocks. Until very recently, the MSCI World Index had outperformed the U.S. stock averages in what had become a multi-year pattern. In a surprise to many, that streak ended in 2010, and we think this year will mark the second year of U.S. outperformance. Compared with the rest of the world, the United States is benefiting from more fiscal and monetary stimulus and has a more innovative economy and better earnings growth prospects—all of which should help U.S. stock market performance.
In contrast, other developed markets are likely to struggle in the years ahead. Europe remains in the grips of serious debt problems and several countries are in the process of implementing austerity measures and monetary policy tightening—hardly an equity-friendly environment. Japan has long faced secular growth problems and the devastation wrought by the earthquake in March will act as at least a short-term drag on the Japanese economy and stock market.
One area outside of the United States that we would highlight is emerging markets. In general, we believe growth in emerging market economies will continue to outpace that of developed markets, but the growth gap between emerging and developed economies is in the process of narrowing. This should also help U.S. stocks on a relative basis.
Walking the line between short-term risks and longer-term opportunities can be difficult, but we believe investors should look beyond the fear and uncertainty of the moment and focus on the long-term picture.
Gains in U.S. equities may be modest, compared to the frenetic pace we've seen recently, and volatility levels are likely to remain elevated. But we remain firm in our belief that this asset class is among the most attractive investment choices.
10 Predictions for 2011
• U.S. growth accelerates as U.S. real GDP reaches a new all-time high.
• The U.S. economy creates 2 million to 3 million jobs in 2011, as the unemployment rate falls to 9%.
• U.S. stocks experience a third year of double-digit percentage returns for the first time in more than a decade, as earnings reach a new all-time high.
• Stocks outperform bonds and cash.
• The U.S. stock market outperforms the MSCI World Index.
• The United States, Germany and Brazil outperform Japan, Spain and China.
• Commodities and emerging-market currencies outperform the U.S. dollar, the euro and the Japanese yen.
• Strong balance sheets and free cash flow lead to significant increases in dividends, share buybacks, mergers and acquisitions and business reinvestment.
• Investor capital flows move from bond funds to equity funds.
• The 2012 presidential campaign sees a plethora of Republican candidates, while President Obama continues to move to the political center.
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