The Outlook

While employment is belatedly moving up, the consumer sector is still facing headwinds. Many have wages that are failing to keep up with rising expenses. Compared with a year earlier, average hourly earnings in the United States were up just 1.7 percent in February. Meanwhile, consumer prices, as measured by the Consumer Price Index (CPI), were 2.1 percent higher in that time. Furthermore, the CPI understates costs to the consumer, as we have discussed in earlier reports.

If costs continue to rise faster than incomes, spending will likely slow and economic growth will slow. We are not expecting a new recession, but do expect growth to slow for the next few quarters and have revised our GDP forecast downward about 0.5 percent. This suggests that gains in employment are also likely to be frustratingly slow this year, a further drag on consumer spending.

On the other hand, corporate profits are at record levels and continue to grow nicely. Even after the major advances in earnings during 2009 and 2010, we expect further increases in profits for many companies in the S&P 500. Profit margins are extremely wide, and many of the higher quality companies have significant cash hoards and low levels of debt. Accordingly, the private sector is exceptionally strong and stands in stark contrast with the huge deficits and consequent debt burdens of our federal government and of most states.

Perhaps it's no surprise then, that U.S. stocks have had a remarkable rebound from lows in March 2009. For example, the broad-based S&P 500 has nearly doubled since then. However, during this same time period, corporate profits have had an even greater recovery. This means that price-earnings multiples remain very reasonable relative to historic valuations. Specifically, S&P 500 earnings should reach levels of $94 to $98 per share this year. This produces a forward-looking multiple of around 14 times earnings. Thus, stocks remain attractive on a valuation basis.

At the same time, we have been expecting a modest correction after the nearly uninterrupted gains of the past two years. From mid-February to mid-March, such a correction seemed to be underway. We thought the devastation in Japan might be the tipping point. But markets have quickly rebounded. With inflation worries likely to increase and with the probable related tightening of interest rates, we still expect a more volatile stock market ahead. Nevertheless, we believe stocks are more appealing than bonds and have positioned client portfolios accordingly.

Disclaimers