Stocks Next Year: More Gains As 'Pessimism Bubble' Pops

From the unbridled despair of 2008 to the only-somewhat bridled optimism of 2009, what a difference a year makes on Wall Street.

A New York Stock Exchange trader.
Oliver Quillia for
A New York Stock Exchange trader.

And so it goes into 2010. Most analysts are offering upbeat forecasts for stocks, though tempered with a healthy dose of what-ifs: whether housing ever does get back on track; whether the Fed raises rates too soon; whether the profligate government spending catches up with the economy and thwarts the nascent recovery.

And, most ominously, whether unemployment continues to prevent the consumer from goosing the economy.

Despite the lingering fears, a return to an armageddon-like scenario is being almost wholly dismissed and investors are enjoying the healthy profits that 2009 offered. This year's 19 percent stock-market profit contrasts handsomely with the nearly 40 percent loss of 2008.

Positive GDP growth—with some estimates as high as the 4 percent range—coupled with continued help from Washington is seen as a solid barrier against fears of a double-dip.

Analysts at Bank of America-Merrill Lynch are calling it the popping of "the equity pessimism bubble."

"As S&P companies deliver strong EPS growth from today's depressed levels, in an environment of healthy global growth led by emerging economies and a slow but steady US recovery, we think we will exit this pessimism bubble in 2010," the firm wrote in a research note that looks ahead to the new year.

The BofA-Merrill Lynch analysis reflects the sentiment of many of the company's peers, with the firm's estimates straddling the 1,250 to 1,350 range that most analysts see for the Standard & Poor's 500 in 2010.

Predictions '10 - See Complete Coverage
Predictions '10 - See Complete Coverage

The firm projects the index to post a healthy gain in the first year of the new decade to 1,275. That would reflect a more than 12 percent gain from the broad index's current level and is predicated on optimism that companies that spent 2009 cleaning up their balance sheets and implementing aggressive cost-cutting measures—read, job cuts—will begin to post real growth in 2010.

As for market leaders, it sees industrials, energy and utilities paving the way for the market to continue the violent rally that began March 6, when investors became convinced that the investing world wasn't coming to an end.

Conversely, the firm downgraded consumer staples and tech and is staying underweight in consumer discretionary.

"We believe that equity investors will come to acknowledge that the low interest rate environment is likely to persist in 2010 as S&P (earnings per share) improves. This will cause stocks to climb higher with higher EPS," BofA-Merrill Lynch wrote. "If stocks do not reach to higher EPS levels and interest rates stay low with fluid debt capital markets, then companies are likely to accelerate share repurchase activity and acquisitions."

In addition to the mentioned sectors, the firm expects financials to play a large role in 2010, but with a caveat. The firm says valuations are still low for the group, and once levels normalize investors should cycle out of that sector and into spaces that have stronger long-term value possibilities, such as tech, industrials and materials.

Caution about the financials is a familiar theme.

Banking analyst Keefe, Bruyette & Woods is forecasting "a tough year for banks" and recommends investors stay with large-caps because of their stronger balance sheets and ability to weather storms that will be harder on their small- and mid-cap brethren.

"For the large-cap banks, we believe investors should focus on companies with stonger balance sheets in 2010, and should invest in banks that will likely reach normalized earnings more quickly, return capital to shareholders through higher dividends than the industry, and continue to benefit from additional acquisitions and FDIC-assisted transactions," KBW said in its year-ahead analysis.

In line with that thinking, KBW has upgraded BB&T, JPMorgan Chase and USBancorp to "outperform."

But analysts recognize the difficulty in pushing the market higher after stocks posted gains of more than 60 percent off the March lows.

The rally put an upbeat close to a decade that otherwise was the worst in Wall Street's history.

One factor seen in favor of a continuation is that the rally has been driven largely by institutional investors, with many retail investors still unconvinced, waiting on the sidelines and holding cash that they've yet to deploy. Combined with a compliant Fed, that should give investors plenty of reasons to get into the market.

"A key element of our optimistic view," wrote analysts at Nomura Securities International, "is the expectation that the authorities will maintain a very accommodative stance for an extended period of time. In addition, the asset allocation position in the US is an extreme one, with both households and institutions holding relatively large amounts of cash. In 2010 we would expect to see a greater appetite for equities developing."

Interestingly, Nomura departs a bit with what has become widely shared sentiment in recent weeks that emerging markets will return to prominence.

"We retain our modest underweight position in global emerging markets," the firm said. "The region no longer offers investors a higher risk premium compared with developed markets. Profitability favors the emerging markets now, but we expect developed market earnings to rise more strongly in 2010 and 2011."

To be sure, there remains caution.

The specter of unemployment not abating through the year is reflected in myriad ways—BofA-Merrill's view on consumer stocks, the willingness of investors to take risk again to name two—but is not the only thing scaring Wall Street.


At some point what has become known as the dollar carry trade—in which investors borrow low-yielding US dollars to invest in other higher-yielding assets—will have to end and the greenback's value normalize.

When the Fed starts pumping up interest rates and the cheap dollar ends, the wild market rally could start to stagger.

"You might finish the year with a small gain relative to where we are, but along the way it's going to be a roller coaster," said Kathy Boyle, president of Chapin Hill Advisors in New York.

Boyle worries that in addition to the dynamics of the dollar trade, any type of geopolitical event could derail the market and force investors to change their strategies.

"The market's been in this flat place for so long that it's built up this coil. So when it breaks one way or another it's likely to go beyond where anyone thinks," she said. "From a fundamental basis there are going to be signs that Wall Street is disconnecting from Main Street."