Why the Long-Term Outlook for Stocks Keeps Getting Brighter

I don't need to tell you that's it tough out there. A pervasive sense of gloom continues to dog many U.S. consumers, most of whom still anticipate more tough times to come, according to consumer confidence surveys. Some recent troublesome economic reports, led by a sharp drop in durable goods orders and an uptick in weekly jobless claims may be early signs that 2012 may be another year of tepid U.S. economic growth. Over in Europe the mood is downright black, as key economies slip into recession, and the weaker countries look headed for more trouble.

 

In that light, I expect a tough market in coming weeks and months -- perhaps as soon as earnings season ends and we're no longer being fed a steady stream of good news. Indeed, the six-month market rally that began in early October appears to have cooled for now: The S&P 500 is on track to finish slightly lower in April.

 

All of the headwinds have taken their toll with investors. The latest survey from the American Association of Individual Investors (AAII) tallies just 27.6% of investors in the bull camp. That's the lowest reading in seven months (though stocks tend to rally sharply when that figure moves to around 25%, as was the case this past October).

 

 

Yet even cautious investors (myself included) have to acknowledge the stunning performance being delivered by corporate America. Profits remain robust -- despite numerous headwinds -- and a case is emerging that profits will keep rising well into 2013. I've had a chance to dig through the updated profit forecasts for various industries now that earnings are rolling in, and it's a good time to get an updated sense of the roadmap ahead.

 

 

Even as consumer spending remains well below the levels seen five years ago (affecting retailers, lenders, and many other industries), companies have managed to already exceed profit levels seen back in 2007. And though it looked as if profit growth may finally start to flatten this year as further margin gains become elusive, first-quarter results imply that the era of profit growth is not yet over. More than 75% of companies have topped profit forecasts thus far. Here's what Merrill Lynch now anticipates for profits in the S&P 500.

 

 

In fact, the 2012 and 2013 profit outlook would be even stronger were it not for the precipitous plunge in natural gas prices, which is pressuring profits in the energy sector. Mining firms are also experiencing profit woes right now. Moreover, U.S. firms that operate in Europe are reporting very weak demand (as Ford (NYSE: F) reminded us on Friday, April 27). Were it not for these headwinds, current and projected profit growth would be nothing short of stunning.

 

 

It's too early to think about what profits for companies in the S&P 500 will look like in 2014, but if these just-noted headwinds abate (i.e. commodity prices firm up and Europe gets off the floor),  we may be looking at $115 or even $120 in earnings per share (EPS) for the S&P 500 by then.

 

Let's focus on Merrill Lynch's 2013 profit outlook in the chart above for now. Today, the S&P 500 trades at about 12.5 to 13 times projected 2013 profits, which is above the 2012-2013 earnings growth rate of 5% to 6%, but below the historical mid-teens market multiple. Merrill Lynch's forecasts are actually among the more conservative views on the Street. The consensus 2013 forecast stands at $119. But it's wise to focus on the low end of the consensus when trying to see the bull case for the market.

 

I've seen a lot of commentary lately saying that it's specious to argue that stocks are cheap compared to bonds (when earnings yields are compared to bond yields). I disagree. Low interest rates (which will surely rise but should stay relatively low in historical terms) are a key factor why companies' profits are so healthy. Low rates enable these companies to make ongoing investments with very low hurdles, since their cost of capital is so low. And that solid-and-rising backdrop for capital spending is what is fueling profits now -- and in the future.

 

 

With the various headwinds in place and corporate profit growth showing no sign of letting up, your coming investment moves should focus on stocks that have solid potential upside but with a tangible degree of downside support. You already know my top ideas in that context: you can find them in my $100,000 Real-Money Portfolio.

But in recent weeks, a host of other solid value/upside opportunities have been emerging on my radar, including:

• Charles Schwab (Nasdaq: SCHW), which I profiled in this article

• Weatherford Industries (NYSE: WFT), which is a global oil services provider trading at a tangible discount to larger rivals such as Schlumberger (NYSE: SLB) and Halliburton (NYSE: HAL)

• AMD (NYSE: AMD), which is an inexpensive way to play rising tech spending

• Delta Airlines (NYSE: DAL), which is managing the current pricey oil environment well, and would be a clear beneficiary of an improving global economy in 2013 and 2014.

 

None of these are hot stocks right now, which may actually be a good thing. You need to be especially wary of holding any stocks that have already made a strong run, as they are likely to be punished most severely if the U.S., European or Chinese economies create fresh market turmoil.

 

Risks to Consider: The global economic headwinds noted earlier need to be closely monitored. Europe in particular is showing recent worrisome signs of a fresh crisis. Also, the looming expiration of the Bush-era tax cuts, coupled with agreed-upon cuts in U.S. government spending, are both expected to take root at the end of this year.

 

That "fiscal cliff" is starting to get on the radars of market-moving fund managers. How that issue gets handled will surely impact longer-term corporate profits in many sectors.

 

Action to Take --> The next few months will be crucial for your investment strategy. The near-term challenges imply that you should be harvesting profits in specific stocks as gains emerge. Yet the longer-term backdrop suggests re-investing funds into stocks that are out of favor now but hold solid multi-year profit opportunities in a rising economy.

 

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