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For Many Market Strategists, Equities Are Top Dog Again

Constance Gustke, |Special to CNBC.com
Monday, 25 Oct 2010 | 9:59 AM ET

Asset allocation strategists haven’t had an easy time in recent years. They’ve grappled with deflation, recession, plummeting U.S. stock markets and surging foreign economies. And for a while they dished out bigger weightings to defensive plays—bonds, cash and commodities.

Close-up of a pen on stock price chart
Close-up of a pen on stock price chart

But in 2011, strategists expect the stock market to notch double-digit gains and recommend investors boost allocations to ride the wave, whether its lower-risk consumer staples stocks or global companies tapping into emerging market supply needs.

“The S&P 500 is growing its earnings,” says Joe Zidle, head of global wealth management investment strategy at Bank of America Merrill Lynch. “And we think that stocks are undervalued relative to historic price-to-earnings ratios.”

Merrill Lynch now allocates 65 percent of its moderate-risk portfolio assets to stocks, versus the standard 60 percent. And Zidle expects equities to return 18 percent in the next 12 months.

Bonds, meanwhile, are underweighted by most strategists, despite the recent safe-haven fixation. Low yields and inflation fears are a concern, which drives down prices. So Zidle and others have reduced bondallocations to 30 percent and lower, versus the 40 percent benchmark.

Overweighting international stocks

Traditionally, asset allocation has been a key to long-term investing, wherein investors shift the balance of assets in small amounts—5 percent to 10 percent—to take advantage of economic and market conditions. (Read: Diversification: Broken or Forgotten?)

Bonds are lower risk and perform best in weak economic times, which tend to bring falling interest rates. Conversely, stocks ride growth spurts. Nevertheless, more than $17 billion has been pulled out of the stock market since 2009.

“That puts investors at risk,” says Zidle. “Over time, inflation is the biggest portfolio risk. Equities are a hedge.”

Within stock weightings, strategists are thinking more globally than usual. They’re over-weight foreign stocksand under-weight U.S. ones. Since 2007, the BRIC countries (China, Russia, Brazil and India) have been responsible for half the global growth, fueling a voracious demand for energy, materials and infrastructure supplies.

“Most growth is going to be in China and India,” says Sam Stovall, chief investment strategist at S&P’s Equity Research Service. “There will also be great growth in Germany and France. Meanwhile, global economic growth is half speed.”

He adds that S&P is currently overweight equities (65 percent) and underweight bonds (35 percent, including cash).

In the past, fears of a double-dip recession hammered equity allotments as low as 50 percent. But Stovall doesn’t see such an economic regression in the U.S., so S&P allotments are now higher. Investors—and companies—will benefit from a weakening dollar, he believes.

“The economy will start to feel better,” adds Stovall. “It used to be a V recovery. This is more like an elongated U.” Slow and steady are the watch words.

That’s why Zidle and others are looking outside the U.S. Indeed, he forecasts 1.8 percent GDP growth for the U.S. in 2011, versus 6.1 percent growth for the emerging market countries.

“You have strong growth outside the U.S.” says Zidle. “But the U.S. isn’t growing much, how can equities go up?”

The answer, he says, is that the S&P 500 companies get 40 percent of their profits from outside the U.S., versus 35 percent of their revenues. “They’re able to do business more profitably overseas."

He also sees global infrastructure as a $6-trillion market opportunity. That includes capital goods and materials companies, such as chemicals, metals and mining, machinery and agriculture.

Hanging onto cash, not bonds

Gail Dudack, managing director of Midweek Securities, has about 60 percent of her total portfolio allocated to stocks, including 15 percent in emerging markets.

She thinks stocks will rise 10-15 percent annually until 2015. Given stock market volatility, however, don’t expect a smooth ride, she adds.

“How do you insulate yourself from a volatile stock markets and overvalued bonds?” she asks. “Find companies with steadily increasing dividends.“

Morgan Stanley also recently noted that dividend payouts and stock buybacks are rising.

Dudack favors undervalued, integrated energy stocks like Exxon Mobil , which have startedto climb back from their April lows.

Zidle sees an additional energy play: emerging market competition for dwindling oil reserves.

“Oil prices will stay high and go higher in 2011,” he says.

Meanwhile, Stovall is overweight conservative U.S. consumer staples companies like General Millsand Coca Cola and household products makers like Procter & Gamble.

He also likes manufacturing stocks, such as Emerson Electric, and is overweight information technology companies such as those in the computer storage and semiconductors businesses.

Many strategists are cutting back on bonds, especially government ones.

“Underweight Treasurys, CDs and agency bonds in your portfolio,” Zidle advises. He, and other strategists, favor investment grade corporate bonds with AA ratings, whose yields are slightly higher.

Stovall recommends keeping bond maturities relatively short. He thinks that interest rates will rise over the next 12 months, noting that ten-year Treasury note yields have fallen to 2.5 percent.

“The Fed will have to engage in quantitative easing,” he adds, “and that will put pressure on yields.”

S&P has 15 percent of its asset allotment in cash and only 20 percent in bonds.

Dudack also has an even larger cash position—20 percent—along with 20 percent bonds.

Still, the economic outlook is hazy for some. “There are a lot of political issues that can change the landscape,” says Dudack. “And the stock market hates uncertainty.”

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