By Edward Krudy Edward Krudy Sat May 28, 7:37 am ET
NEW YORK (Reuters) The world looks a lot more dangerous than it did only a
few months ago and signs are that U.S. stock investors are starting to demand
more for the added risk.
With important manufacturing and jobs data due next week, it could start to get
even riskier.
That means nervous investors are likely to keep a lid on equity prices this
year as they grapple with slowing global growth and a host of geopolitical
risks from the Arab Spring to debt defaults in the euro zone.
The actions of some big Wall Street banks best show the shift in the
risk-reward nexus. Over the last two weeks, UBS, Citigroup and Goldman Sachs
have effectively lowered their view of what investors will be willing to pay
for a dollar of corporate earnings this year.
Jonathan Golub, chief U.S. equity strategist at UBS in New York, made the
decision to keep his S&P 500 Index target on hold, even though he increased his
expectations of what S&P 500 companies would likely earn this year and next.
"Earnings are going to continue to surprise to the upside, but investors will
continue to be reluctant to believe in the sustainability of earnings and,
therefore, not give full credit to that," Golub said.
Golub raised his average S&P 500 earnings estimate to $101 from $96 for this
year, but he left his year-end S&P 500 (.SPX)target at 1,425. By doing that,
Golub has effectively lowered his price-to-earnings (P/E) ratio -- the amount
investors are willing to pay for a dollar of earnings -- to 14.1 from 14.8.
That amounts to an increase in the expected equity yield -- a measure of the
return investors want -- to 7.1 percent from 6.8 percent.
That is significant because the expected price-to-earnings ratio was already
below what investors have historically been willing to pay for S&P 500
earnings. The average trailing P/E ratio is 15.6 over the last five years and
19.2 since 1988, according to Standard & Poor's.
Golub argues that a batch of weak economic data pointing to slowing
manufacturing, a weak housing market and stubbornly high unemployment is
weighing on investor sentiment. Weakness in commodity markets and rotation into
defensive sectors of the stock market testify to that shift.
SOFT JOBS DATA MAY HIT S&P
With next week's ISM national manufacturing survey for May expected to show
more weakness and payroll data tipped to show under 200,000 jobs added during
the month, risk aversion -- driven by fear about the economy -- could get worse
before it gets better.
Goldman Sachs economist Zach Pandl said his firm is predicting 150,000 jobs
were added in May, compared with a Reuters consensus of 185,000.
An ISM reading below 60 next Wednesday would show "the strongest period of
growth has passed and investors may need to adjust their expectations going
forward," said Michael Sheldon, chief market strategist at RDM Financial in
Westport, Connecticut.
Economists in a Reuters poll expect the ISM reading to fall to 58 in May from
60.4 in April.
Goldman Sachs has also been tweaking its stocks outlook. It cut its year-end S&
P 500 target, one of the highest on the Street, to 1,450 from 1,500, and
lowered its 2012 earnings outlook to $104 to $106, citing lower global growth,
higher commodity prices and slightly higher inflation.
Goldman analyst David Kostin, who is responsible for the S&P 500 target, was
unavailable for an interview.
However Goldman's analysts wrote: "As we transition into the late expansion
phase of the cycle later this year, the risk-reward balance for the S&P 500 is
likely to become slightly less attractive."
Citigroup also slightly increased its earnings estimates for S&P 500 companies,
lifting its 2011 forecast to $98 from $96.50. Although admittedly only a small
increase, it chose to leave its S&P 500 target at 1,400.
Tobias Levkovich, Citigroup's chief U.S. equity strategist, could not be
reached for comment.
The targets for all three banks are still at the upper end of analysts'
estimates and are 5 percent to 8 percent above current levels.
Even if the index does get up to those levels later this year, those gains are
slight compared to the near 80 percent run the S&P 500 has experienced since
hitting a bear market low in March 2009.
For people like Bill Strazzullo, partner and chief investment strategist at
Bell Curve Trading in Boston, that means the risks are firmly on the downside.
"The good news is there's some upside. The bad news is that you've probably
made about 80 (percent) to 90 percent of this rally," Strazullo said. "From a
'bigger picture' standpoint, the risk-reward really doesn't make sense."
Strazullo believes the S&P 500 will revert toward fair value, which he places
at 1,100, based on where most of the money in the S&P 500 is invested. He is
looking at some longer-term bearish options trades to capitalize on the end of
the March 2009 rally.
"I'm not saying we'll go all the way back there, but the point is, you could
drop a lot further than most people anticipate."
(Reporting by Edward Krudy; Additional reporting by Rodrigo Campos; Editing by
Jan Paschal)