U.S. Stock Outlook Turns Murkier

While a recent rebound has reassured investors, some say stocks may not keep pace with corporate earnings

By E.S. BROWNING
Nov. 8, 2015 5:30 a.m. ET

Stocks hit a speed bump late last week, raising questions about the durability of a roaring autumn recovery.

While the rebound from the late August lows has reassured anxious investors, it has put stocks back in the same predicament they faced in May, when the Dow industrials last set a new high: They are expensive.

Some money managers and analysts say stocks have risen so much they may not keep pace with corporate earnings, which are looking unsteady. The prospect of a Federal Reserve rate increase, considered likely after Friday’s strong report on October wages and job creation, makes the stock outlook even murkier.

“This has been one of those hope-driven rallies, based on the idea that central bankers will come to the rescue if the data get worse,” said Anwiti Bahuguna, senior portfolio manager at Columbia Threadneedle Investments, which oversees $471 billion. Asked if the recent rally is sustainable, she said, “I don’t think so.”

Her firm has reduced U.S. stockholdings and increased cash reserves, she said. A variety of other money managers said they also have large cash positions, just in case. Some have reduced holdings in Europe and Japan, while others are limiting their cuts to the U.S.

The Dow Jones Industrial Average has surged 14% since its Aug. 25 low. The S&P 500 now trades at 23 times its companies’ net profits for the past 12 months, far above the 15.5 historical average and above the level of 20 hit in September, according to Birinyi Associates.

David Kostin, chief U.S. stock strategist at Goldman Sachs Group Inc., forecasts that the S&P 500 will average a total annual return of 5% for the next 10 years, including 2% from dividends and 3% from price gains.

He forecasts that the S&P will fall about 4% between now and year-end, not including dividends, leaving the index down about 2.9% for 2015. He projects a 5% index gain in 2016, with dividends adding 2% more.

His reasoning: Higher interest rates will hold back stock gains by making money less easily available. With stock prices well above average by most measures, the ratio of prices to earnings should decline as rates rise, meaning stocks will likely rise more slowly than profits.

“That combination leads to a slowly rising stock market,” Mr. Kostin said.

John Bogle, the retired founder of investment giant Vanguard Group, recently used similar reasoning to forecast a 4% S&P 500 average annual return over the next 10 years. He told Morningstar Inc. the return would be further reduced by inflation, fees and expenses.

That would mark a sharp break from the past six years. The Dow Jones Industrial Average has risen 174% from its 2009 low and the S&P 500 is up 210%. Both are within 2.5% of a record, nearing levels where they topped out in May, June and July.

On Friday, the Dow rose 46.90 points, or 0.26%, to 17910.33, but the broader S&P fell 0.03%, leaving it down for the past three trading days.

Not everyone is expecting weak stock performance. Stocks often have their biggest gains in the last three months of the year. Some predict a global economic revival next year, fueling more gains. Few expect an outright bear market, or a decline of 20% or more.

One reason for optimism is that the world’s central banks are committed to keeping interest rates low, helping to support stock prices. Even if the Fed raises rates over the next year, many expect its target overnight rate to remain well below 2% through 2016, very low by historical standards.

Still, the outlook looks less appealing than it was earlier in this six-year bull market.

Following Friday’s strong jobs report, expectations rose that the Fed will raise its target overnight interest rate by 0.25 percentage point in December, the first rate increase since 2006.

Analysts project corporate earnings for S&P 500 companies will fall 0.6% for 2015, according to FactSet. Falling oil prices have hurt energy-company results and the strong dollar has reduced multinationals’ profits.

Corporate revenues are doing even worse. Analysts forecast a revenue decline of 3.3% this year, FactSet reported.

Cost-cutting has helped companies boost profits, but many economists think they are getting to the limit of their cost-cutting ability. If so, future profits depend on sales growth, which has been weak.

Analysts are forecasting an 8.3% profit rebound in 2016. But such early forecasts typically get reduced over time, and uncertainty about oil prices, the dollar and earnings leaves many money managers worried, especially with the Fed poised to raise interest rates.

“Stocks might struggle in the first half of the next year,” said David Joy, chief market strategist at Ameriprise Financial Inc., which oversees $766 billion.