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Are Stocks Overvalued or Poised for More Gains?

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There’s a growing divergence among strategists about the outlook for stocks.

BlackRock strategists are bullish on equities because of what they call a “synchronized and sustained economic expansion” in the U.S., Europe and Asia coupled with continued low interest rates and earnings growth. (FactSet says earnings could grow near double digits for the second quarter.)

“Valuations can be sustained at current levels” given the current “expansion with low yields,” said Richard Turnill, BlackRock’s global chief investment strategist, at a breakfast meeting with reporters. He expects the economic expansion, now in its eighth year, will continue because it’s been slower than previous expansion cycles and interest rates remain low.

“Investors are paid to take risk especially in equities outside the U.S.” and run the risk of not owning enough stocks, in particular European, Japanese and emerging markets stocks, according to Turnill.

Jeffrey Saut, chief investment strategist at Raymond James, agrees that the bull market can continue to run because secular bull markets tend to last 14 to 18 years and the current one arguably began in April 2013, when stocks broke out of their previous trading range, not in March 2009, when the major U.S. stock market indexes hit bottom, which is the more widely perceived start date. In either case, according to Saut, the bull market is nowhere near its end.

Bank of America Merrill Lynch strategists take a very different view. They see “growing signs that the bull market is aging” and “getting weary,” according to their second-half outlook report. As a result, they recommend that investors reduce stock market allocations, especially to U.S. small-cap and emerging market equities; take some profits; rebalance to “under-owned sectors” such as health care and industrials; and shift more funds to cash.

The rationale for these recommendations, beyond an aging bull market:

  • a stock market capitalization near 130% of U.S. GDP, which is close to peak levels
  • more levered balance sheets for small- and mid-cap companies
  • companies with high-yield debt are trading at discounts to those with higher quality debt
  • small- and mid-cap stock performance lagging that of large-cap stocks – the opposite of what tends to happen when markets are doing well
  • central banks continuing to remove liquidity from markets

For all these reasons, BofA strategists write that “stocks will become increasingly vulnerable to a meaningful pullback.”

But investors don’t seem to be worried. Envestnet, which provides integrated portfolio, practice management and reporting solutions for financial advisors and institutions, reports that investors are more, not less, optimistic about the stock market. They’re increasing allocations to aggressive stock portfolios while decreasing allocations to more conservative strategies, as stocks continue to advance against a backdrop of “surprisingly low volatility,” according to Envestnet’s database.

Referring to the clients of the advisors on its network, Envestnet reports that they’re “more comfortable now taking risk in equities versus 12 months ago when in fact they should be getting more risk averse since markets are at an all-time high.”

Its advice to advisors: “Unless a client profile has changed, their risk profile should be maintained. …Talk to clients about the trade-offs of adding risk to a portfolio, drawdown potential, time to recover, what duration risk is, and more.”

BlackRock strategists admit that valuations of stocks are on the high side in the U.S. but not elsewhere – not in emerging markets, Europe, Japan or emerging markets, which are trading at a 20% to 30% discount to U.S. equities. BlackRock is neutral on U.S. equities and overweight Europe, Asia including Japan, and emerging market stocks.

“Emerging market earnings have improved considerably after five weak years” and “haven’t yet priced in the best case scenario,” said Kate Moore, BlackRock’s chief equity strategist.

She’s even bullish on U.S. tech stocks, which have been among this year’s top U.S. performers and the source of much of the nervousness about valuations. Tech stocks have become a “big momentum trade because of fundamentals, not sentiment,” said Moore. The sector is “well-owned and well-loved but that may make it vulnerable to pullbacks.”

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