Ed Yardeni is president and founder of Yardeni Research, a global investment research strategy firm. A former economist for the Federal Reserve Bank of New York, he is widely followed by institutional investors for his investment strategy publications. Dr. Yardeni is often seen on CNBC and is published in financial publications like the Wall Street Journal, New York Times and Barron's.
Dr. Yardeni recently sat down with ETF.com to discuss why small-caps are underperforming large-caps and compares valuations between different markets. He tells us why he prefers corporate bonds over Treasurys and why the U.S. dollar is likely to remain strong in the coming year.
ETF.com: The S&P 500 has now hit your year-end target number of 2014, with three months left in the year. Do you have a new target now?
Ed Yardeni: I had the same "problem" last year, when my year-end target for 2013, which was 1,665, was hit in September. In September of last year, rather than tweak the year-end forecast, we started talking about a target of 2014 in the year 2014. It's close enough to year-end that I didn't really see much point in fine-tuning the forecast. So now, that's sort of a repeat. We've got our target achieved here, so we're now talking about next year. I'm going to leave my year-end target the same.
We can just stumble around here for the rest of the year, since I think the market needs to consolidate a little bit. In addition, we're seeing some internal correcting, and internal correction in the market, which has been going on all year, with investors moving out of high P/E stocks into lower P/E stocks, so that they're mostly moving out of small-cap into larger-caps. So next year, we're thinking of 2,300 for the S&P 500 before the end of next year.
ETF.com: You mentioned investors rotating out of small-caps into large-caps. In an interesting twist, small-caps have underperformed large-caps since spring. Some investors view small-caps as a leading indicator. Does that concern you at all?
Yardeni: You have to be concerned because there have been precedents for this. It's not a happy signal, obviously. It's better to see a bull market broadening than narrowing. But I guess the concern would be that if it's not just an internal correction, but it's a signal that the recession is coming, that would be something to worry about. Typically, in the business cycle context, small-cap stocks perform very badly in recessions.
But I don't think the weakness of the small-caps reflects investors' concerns that a recession is coming in the U.S. It's kind of a reaction to last year. Last year these small-caps had an extraordinary outperformance. They're just getting back some of the gains. But, rather than moving out of the market, I see investors moving towards cheaper stocks, and most of them tend to be larger-caps.
ETF.com: Three months ago, you preferred defensive sectors, such as health care and utilities. Do you still favor "defensive" sectors? Or do you like cyclical sectors right now?
Yardeni: These days, the old definitions of what is cyclical and what is defensive needs to be amended. Health care has actually become a very aggressive play, especially when you look at biotechs and health care technology. There's quite a bit of technology these days in health care. They've done well. So I still like them.
Utilities have been an odd sector this year because the gas utilities have done extremely well. That's really been more a play on the cost of energy, rather than a play on the bond market. Though clearly, utilities have done well, in part because bond yields have done the opposite of what most people thought, that those yields would come down.
At this point, I would stay with health care. I would get a little bit more cyclical with industrials, which have underperformed, and in prevention technology, which has done well, but I think should continue to do well. Financials are appealing, mostly because they're cheap. If investors are looking for relatively low P/Es, they're in financials. Financials have substantively been a market performer. But they could be an outperformer if the U.S. economy continues to grow reasonably well.
ETF.com: You raised an interesting point that it's tough to find a defensive sector now. So how do you get defensive?
Yardeni: The focus would have to be in blue-chip, large-cap stocks. They're not cheap, but they're certainly cheaper than small-caps, midcaps. If you're looking at this on a valuation basis globally, emerging markets are still relatively cheap compared to some U.S. valuations. But you really have to know what you're doing, or just buy a broad ETF. The global economy is likely to continue to grow.
A lot of emerging economies are becoming less dependent on exporting commodities of labor-intensive products as their domestic markets are growing. I don't think it's so much a question of defensive versus cyclical. The big question is valuation. On a relative basis, the cheapest stocks are in the emerging economies, selling on a multiple around 11½. On the other hand, you could pay something like 15½ P/Es for U.S. large-caps. So they are more expensive. But compared to small/midcaps, they are still pretty cheap.
If you want to get really defensive, then you wind up being in the short end of the bond market or in the money markets. But preserving your capital is not going to give you any significant return.