The View From S&P

July 13, 2007

Standard and Poor's top analysts gaze into their crystal ball to see where the market is headed from here.

For much of the discussion in Standard & Poor's (S&P) Second Quarter Earnings Forecast Teleconference, moderated by S&P vice president of content management and development Bill Glasgall, share buybacks and M&A were the hot topics. After all, earlier this year, S&P announced that companies in the S&P 500 had spent a record-breaking $118 billion on repurchasing shares in the first quarter, up from $31 billion in the first quarter of 2001. M&A activity has also been at record levels, not only in the U.S. but at the global level, with $4 trillion in activity expected worldwide for 2007.

As the first presenter on the call, Howard Silverblatt, senior index analyst at S&P, traced the roots of the upsurge in stock buybacks to the bear market of 2000-2002. Companies that had spent heavily during the tech boom became "gun-shy of commitment" during the bear market, he said in his presentation on second-quarter earnings estimates. Operations were relocated abroad or outsourced due to globalization, while the corporate scandals and ensuing corporate governance movement left management, in Silverblatt's words, "perfectly content to live in its own world, cutting costs, with little investment."

When earnings began to rise and shareholders responded by becoming more active, companies at first issued more dividends but could not keep up with earnings growth. Share buybacks seemed like a way to keep everyone happy and led to the term "share count reduction," or SCR.

One of the drawbacks of the share buybacks, however, has been that they have inflated earnings. "Last year almost a quarter of the [S&P] 500 issues increased their earnings at least 4% that way," said Silverblatt, adding that in 2006, S&P 500 companies spent more on buybacks than the U.S. government spent on Medicare.

The distortion in earnings affects price-to-earnings ratios (P/E ratios), pushing them down. In the wake of the tech meltdown during the bear market, high P/E ratios are viewed somewhat warily. "Investors need to remember: While paying 18x operating earnings is acceptable, if a quarter of that growth is coming from buybacks, it's a totally different investment," Silverblatt said.

Mergers and acquisitions have also exploded because of the excess cash available and the pressure on companies to generate earnings. Eighteen deals were on the table involving S&P 500 companies at quarter-end, well over half with private companies and only two with companies in the S&P 500. Previously, Silverblatt said, the most common reason for a company dropping out of the index was acquisition by another index component.

Silverblatt noted concerns around consumer spending, citing low home prices, high interest rates, high oil prices and the low likelihood of any further tax cuts, among other issues. However, he took a positive view of the current state of the stock market, noting that companies were in the best shape they have been in years. He noted a gently declining earnings trend after 18 quarters of strong earnings and pointed out that there were no dire indications regarding recession, unemployment or interest rates.

"If this is the payback for four and a half years of rapid growth, sign me up again," he said.

 Although double-digit growth should return eventually, for now investors should not worry about when that will happen and simply look to position themselves by investing in companies with strong management teams, cash reserves and cash flow, Silverblatt concluded.

The Recovery Continues

Sam Stovall, chief investment officer at S&P, gave a midyear update on the outlook for 2007. He noted that as of May 30, the S&P 500 had just returned to its pre-bear market high of 1527 after an unusually long 56 months. The average time period for such an occurrence is 33 months.

The most recent pullback is typical of a market that has hit its previous high, he said. Stovall also does not expect a correction this year based on historical data, although there is typically a correction one to three years after reaching a new high in a bull market. However, he did warn of increasing volatility in the wake of the Shanghai Tsunami, as the global-market-rattling plunge in the Chinese stock market this February is being referred to.

"It's a little like moving from a paved road onto a dirt road: You can still get from here to there, but the ride is a little bumpier," he said.

Mergers and acquisitions and earnings are key drivers of the current market, Stovall added. Year-to-date M&A activity at the global level was up 56% from the same period in 2006, with most of the increase coming from the global Consumer Staples and Financials sectors. Telecommunications was a major exception, with M&A activity down 44%.

For the quarter, Stovall said S&P estimated 5.7% earnings growth for the S&P 500, but also said that it could be more. Stovall added that the 10-member S&P investment committee was somewhat divided on expectations for the longer term, but had set a year-end target for the S&P 500 of 1510.

According to Stovall's presentation, S&P was positive on large- and mid-cap value and on Europe and the emerging markets. It was also positive on the S&P 500's Consumer Staples and Health Care sectors. It was negative to neutral on the small-cap segment and negative on growth and the Consumer Discretionary, Materials and Utilities sectors.

"In general, our expectation is stay with stocks but don't get too aggressive," Stovall said, recommending a slight underweighting in U.S. stocks and a slight overweighting in international stocks.

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