The U.S. Federal Reserve is scheduled to complete its third round of quantitative easing this month, prompting many market participants to wonder if another rout is in the offing. Following the wind-down of the first QE program, in March 2010, the S&P 500 Index tumbled 9 percent; when the second iteration ended, in June 2011, shares fell nearly 12 percent. Directors of equity research at some of the most prominent U.S. brokerages believe, however, that this time will be different.
“Unlike QE1 and QE2, QE3 is not ending abruptly, but is rather being tapered down over the course of ten months,” notes Nicholas Rosato, who in May replaced Noelle Grainger as head of North American equity research at J.P. Morgan. (Grainger was promoted to director of global equity research.) This approach was designed to reassure investors that the central bank would only ease out of the bond-buying business as the U.S. economy improved. “It seems that this has had the desired effect on confidence, as this prolonged tapering has resulted in asset prices responding favorably. Our strategists see no reason why that won’t continue for the very last tapering step.”
Brett Hodess, director of Americas equity research at Bank of America Merrill Lynch, shares a similar view. “While a pullback on the end of tapering is likely, the bearish sentiment, high cash balances of fund managers and the well-telegraphed end of QE3 — which is at least partly discounted in stocks — would likely limit any ‘taper tantrum’ to the 5 percent or less range,” he believes. “In addition, we had external shocks around the time of the first two QE policy shifts, such as the euro zone crisis and the fiscal brinkmanship moments in Washington, which contributed to those drops.”
A better macroeconomic environment this time around should help, agrees David Adelman, who in September replaced Stephen Penwell as director of Americas equity research at Morgan Stanley. (Penwell now oversees the firm’s North America Stock Selection Committee.) “The slowdowns that followed the ends of QE1 and QE2 were also accompanied by soft patches in the U.S. economy. Therefore, it is difficult to extract how much of the subsequent weakness was due to less-accommodative policy and how much to a slower growth outlook,” Adelman observes. “We generally remain sanguine today about the U.S. economy and hence are not anticipating a sharp correction post the tapering of asset purchases.”
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Still, investor anxiety is understandable, given not only the history of the bond-buying programs but also contradictory signals about the strength of the U.S. economic recovery. Late last month, for instance, the Bureau of Economic Analysis revised its second-quarter real gross domestic growth estimate from 4.2 percent to 4.6 percent, tying the postrecession high set in the final three months of 2012, while just one month earlier job growth was slower than it had been all year.
Many fund managers will be asking sell-siders for help in interpreting the signs that will emerge in a posttapering world, and the firm whose analysts are considered the most insightful is J.P. Morgan, which tops Institutional Investor’s All-America Research Team for a fifth year running. Its analysts earn a spot in 42 sectors, five fewer than last year and just one more than the outfit that repeats in second place, BofA Merrill, whose team position total is unchanged from 2013. Look beyond these top-line results, however, and a wider disparity emerges. Nearly half of J.P. Morgan’s ranked analysts and teams capture first place in their respective categories, compared with just six for the No. 2 firm. BofA Merrill’s total includes 21 runner-up positions, as opposed to nine for the winning brokerage. In fact, when a rating of 4 is assigned to each first-teamer, 3 to each second-teamer, and so on, J.P. Morgan claims a weighted total of 123, far in front of BofA Merrill’s 80. (See “Weighting the Results”.)
Click below for an infographic highlighting the results of the 2014 All-America Research Team survey.
Returning in third and fourth place overall are Morgan Stanley and Barclays, with 30 and 28 spots, respectively; these totals reflect a loss of three positions for each firm. ISI Group rockets from tenth place to fifth after increasing its total by six, to 23, including nine sector-topping performances — more than any other firm except J.P. Morgan. In August, ISI agreed to be acquired by Evercore Partners, an investment banking advisory firm based in New York.
These results reflect the opinions of more than 3,600 individuals at 1,017 firms that collectively manage an estimated $10.9 trillion in U.S. equities. The images on the surrounding pages highlight some of the researchers voted No. 1 in their coverage areas.
Among the industries sending mixed signals is residential construction. Housing starts plunged more than 14 percent in August after surging 11.1 percent in July. Nonetheless, the National Association of Home Builders/Wells Fargo builders sentiment index notched its fourth straight monthly gain and hit a seven-month high in August.
“The recovery is now job-dependent and credit-dependent,” declares ISI’s Stephen East, who vaults from runner-up to first place for the first time in Homebuilders & Building Products, unseating longtime sector champion Ivy Zelman of Zelman & Associates. “In 2012 and 2013 it was more about low rates and affordability. Much of the affordability buying has occurred, and we are now back to traditional drivers of housing — primarily jobs and household formations,” or the ways in which individuals band together to share accommodations. “On average, two jobs created generates one household formation,” the St. Louis–based analyst continues. “We believe the recovery will be much more consistent if the economy can generate 200,000 to 250,000 jobs per month.”
Job growth averaged 212,000 a month in the year through July but dipped to 142,000 in August, according to the Labor Department.
“Another issue is credit availability — or lack thereof,” East says. “The first-time buyer, in particular, has been hard hit by excessively tight credit standards, preventing many from buying. Standards have eased a bit but remain well above historical norms. Until banks lend more broadly, the housing market will continue struggling.”
Even so, the analyst is upbeat. “If we generate 200,000-plus jobs a month, as ISI’s economists believe we will, then the new-home market will accelerate its growth in 2015,” he says. “In that scenario we believe both homebuilders and building-products companies will outperform.”
Also poised to best the broad market in the year ahead are many software names, according to BofA Merrill’s Kasthuri Rangan, who rises from second place to claim his first appearance atop the sector lineup. “This is a segment of the market that had been given up for dead — ignored as investors sought the safety and liquidity of large caps,” the San Francisco–based analyst says. “But as people start to realize that interest rates aren’t going to go a lot higher, we could be set for a period when people get ignited by their love of growth investing.”
To fuel their expansion, however, many companies will have to reorganize their operations, he adds. “They’re going to have to go for a cloud-based business model, which is far stickier with the customer,” Rangan explains. “Cloud computing is a tiny segment of the [information technology] landscape — it’s only 3 percent of all IT spending — and we think this number is going to grow dramatically.” Many software providers have already begun the necessary transformation, he adds. The analyst’s current recommendations include two San Francisco–based outfits — Salesforce.com, a developer of client relationship management software, and Splunk, which makes products that search and analyze machine-generated big data — as well as VMware, a provider of virtualization software that is headquartered in nearby Palo Alto.
Rangan’s colleague Douglas Leggate also advances the final rung to claim a sector crown for the first time, in Integrated Oil. (He also secures a runner-up spot in Oil & Gas Exploration & Production.) Many investors are well aware of the boom in shale oil production in the U.S., but opinions differ as to whether its current growth trajectory is sustainable. Leggate, who is headquartered in Houston, believes it is.
“It’s been remarkable, and at least based on the forecasts for industry activity, we expect the pace of development will continue to rise,” he says. “The smaller E&P companies really led the growth of the past five years. Larger companies, with significant legacy acreage, are only just getting started — and the prospects for another step-up in production that can sustain growth through the end of the decade are in place.”
Maximizing recovery is a key issue that the industry is struggling to address. “Recovery rates are still well below 10 percent of the oil in place,” Leggate says. “We believe the pace of growth can still accelerate as the industry optimizes development plans. The U.S. is already the largest oil producer in the world. In our view, production can reasonably increase by another 50 percent from here, if the regulatory and oil price environments allow.”
The analyst currently favors “asset-rich E&Ps with strong balance sheets and execution capabilities to bring forward value through growth,” he says. Hess Corp. of New York and Houston-based Occidental Petroleum Corp. are two of his preferred picks. “We adopted a more cautious stance on the refining sector earlier this year,” Leggate adds. “Until we get some clarity on future U.S. oil export policy, our view is this sector will remain challenged.”
Regulatory concerns are also creating headwinds for big banks, according to John McDonald of Sanford C. Bernstein & Co. Last month the Fed announced plans to impose a surcharge on the nation’s largest financial services providers, above the amount set forth in Basel III. The level of additional capital has not yet been determined.
“The Fed is sending a message that it wants U.S. banks to become smaller and simpler,” explains McDonald, who climbs from second place to first in Banks/Large-Cap. “It will impose higher capital charges on the largest, most complex banks to reduce the probability of their failure and to lessen the consequences when they do fail.”
These fees will likely result in lower return on equity for the institutions, thus leading to lower valuations for their stocks, he believes. “However, these negatives could be mitigated by the value that gets untrapped as banks downsize and by potential higher multiples afforded to bank stocks because they are viewed as safer and more predictable,” McDonald says.
His colleague Joshua Stirling, who is No. 1 in Insurance/Nonlife in only his second year on the team, is bullish on the prospects of some companies in his coverage universe. “We see American International Group as well positioned to drive earnings growth,” says Stirling, who works out of Boston. “Since its death and rebirth during the financial crisis, AIG has the leverage to outperform as it transitions from a sprawling and historically undermanaged firm to a modern, disciplined and streamlined underwriter.”
The New York–based multiline insurer has invested in both talent and technology, he adds, and become better at assessing risk and settling claims. “Over time we expect the company to bring its operating margins in line with peers’, and as they compound book value and raise their ROE to double digits — they’re still only trading around 75 percent of book value — we see an opportunity for patient money to double or more,” Stirling predicts.
Another analyst who sees openings for investors to make money is Justin Lake. He captures first place in two sectors, Health Care Facilities and Managed Care, for a second consecutive year. “Health care facilities have outperformed the S&P by about 30 percent year to date,” the J.P. Morgan researcher reports. He believes the rally is sustainable. “We’re only in the second inning of implementation [of health care reform]. Second-quarter earnings were revised higher for just about all the hospitals, and I believe this earnings pattern will continue over the next six to 12 months. I’ve got buy ratings on all the hospitals I cover.”
One of the catalysts that will spur growth is Medicaid expansion. The Patient Protection and Affordable Care Act, better known as Obamacare, raised the income limit to 133 percent of the federal poverty level so that more people would qualify for coverage, but the Supreme Court ruled that states could not be forced to participate. “Only about half the states have expanded Medicaid as part of health care reform, but I think that’s destined to be 50 states over the next three to five years,” Lake says. “If you look back at the rollout of Medicaid, in 1965, only about half the states opted in at first. Over a three- to five-year period, we were pretty close to 50.”
Americans in all states are sending mixed signals about their belief in the economic recovery. Last month the University of Michigan’s Index of Consumer Sentiment surged to its highest level in more than a year, 84.6, but spending remains mostly flat.
“Restaurants have been battling the same paradox as the rest of retail — sluggish spending even as confidence and the overall economy improves,” attests Morgan Stanley’s John Glass, who celebrates his fifth straight appearance atop the Restaurants sector roster. Such higher-end chains as Denver-based Chipotle Mexican Grill and Starbucks Corp. of Seattle are doing well, he notes, “while the rest are still waiting for the recovery to begin. Expect continued price discounting as brands try to drive traffic.”
The analyst definitely sees the sector glass as half-full, so to speak. “We’re optimistic about the future,” he says. “There will be a gradual recovery, with lots of new concepts coming of age. Fast casual will continue its growth. Casual dining is and has been the most secularly challenged, but it’s far from dead. The segment needs restructuring, with business models that reflect the realities of today’s challenges.”
The same can be said about many of the companies covered by Tien-Tsin Huang, who spent the past five years in second place in Computer Services & IT Consulting and this year captures the top spot for the first time. “My sector has uncharacteristically underperformed the market this year, after posting strong outperformance in 2013,” the J.P. Morgan analyst affirms. “Multiples remain healthy, but we’ve seen fewer positive earnings surprises to push stocks higher as the pricing environment remains muted and volumes stay stable.”
Even so, Huang is unabashedly bullish on payment processors. “Visa and MasterCard have faced various growth headwinds and uncertainties, including regulation, foreign exchange and technology disruption fears, underpinned by a tepid global consumer recovery,” he explains. “We expect these headwinds to fade, as enough time has passed for both firms to adapt, introduce new services and reprice for value and growth.”
The market as a whole is adapting to a posttapering environment, believes BofA Merrill’s Hodess. “We are shifting from a Fed-stimulus and consumption-driven bull market to a more midcycle bull market,” he says. “With companies’ balance sheets and cash flows generally in great shape, and corporate spending way below normal, our take is that we are shifting to a capital-spending-driven market.”
The best may be yet to come, contends Morgan Stanley’s Adelman. “This may be the longest expansion ever — perhaps lasting until 2020,” he says. “Equity exposure in above normal percentages is prudent.” • •
