Why Stocks Are About To Rally & Where To Be

Brian Jacobsen, Ph.D., CFA, CFP, is chief portfolio strategist at Wells Fargo Funds Management. In addition to his role at Wells Fargo conducting research and giving presentations on the markets and the economy, he is an associate professor at Wisconsin Lutheran College. Jacobsen’s research and teaching center on economics, finance and investing. ETF.com recently caught up with him to get his thoughts on the global economy and financial markets.

ETF.com: It's still early in the Q3 earnings season, but it looks like we could have six-straight quarters of negative year-over-year corporate earnings growth for the S&P 500. Is that a concern for you?

Brian Jacobsen: No, it's not. I don't find a lot of value in comparing the current quarter's earnings to the earnings of four quarters ago. I find more value in thinking about what earnings will look like four quarters from now.

The earnings recession ended in the first quarter of 2016 when you look at it on an incremental basis. That's what I like to do, because what's really important is whether the trajectory of earnings has changed.

Going from the fourth quarter of 2015 into the first quarter of 2016, earnings actually increased quarter-on-quarter. Sure they were down year-on-year, but the most important thing is that they continue to do the slow march higher.

ETF.com: We saw the S&P 500 at a new high this summer, though it's pulled back a little bit in the last several weeks. The last time we spoke, you were bullish on the market; is that still the case?

Jacobsen: That's correct; I am still bullish on the intermediate-term outlook, or the next 12 months. In my view, within the next 12 months, the S&P 500 will probably hit 2,400.If you're somebody who likes to trade a little bit more frequently, you still need to stay a little nimble. We're 2.5% off the all-time high.

It's possible that earnings season might not pan out as nicely as a lot of people are hoping. That could create a move down toward 2,100 on the S&P, which might be a better entry point. But for longer-term investors, the current level of 2,140 compared with 2,100 might not matter much.

ETF.com: Do you see better value in large-caps, midcaps or small-caps?

Jacobsen: I prefer midcaps, mainly because they've underperformed over the last few years. Typically, when they've underperformed for a few years, they enter a period of outperformance.

One of the key things I like to look at is what analysts are saying about the next five-year growth rate of earnings per share. In most areas of the market, growth expectations are still well below their historical averages. It's just that in midcaps, they're even further below their historical averages.

As long as we see an economy that isn't rolling over into a recession, people might ratchet up those long-term growth rate expectations, and the midcap space is simply the area where there's the most room for a ratcheting up of expectations.

ETF.com: Are there any particular stock market sectors you like or would avoid? It looks like utilities, telecom, energy and tech have done well this year.

Jacobsen: They have. Not only are utilities and telecom interest rate sensitive, they're also viewed as defensives, which is something they've had going for them. As interest rates have fallen, their stock prices have gone up. Plus, people are still a little bit nervous about the sustainability of this bull market.

But the interest rate story is changing. I believe we’re probably going to see the 10-year Treasury yield end the year close to 2%, as opposed to close to 1.5%—meaning that the interest rate sensitivity of utilities and telecom could come back and bite you.

As far as with tech, there's still room to run. Some of the best-performing technology stocks of the past year were the FANGs [Facebook, Amazon, Netflix, Google]. There's going to be more of a focus on quality as opposed to momentum in the technology space going forward.

While I'd underweight utilities and telecom, I'd still run with information technology here.

ETF.com: You touched on interest rates and how you see the 10-year bond going to 2% by year-end. In that rising-rate scenario, what areas of the bond market do you like the best?

Jacobsen: High-yield bonds are relatively more attractive than other parts of the fixed-income market. However, those spreads are about average, and there isn't the same cushion with spreads as what we had, say, back in January, February or March.

There might not be as much room for the high-yield bond market to absorb a general increase in interest rates. But it would still be my preferred place for riding out an increase in interest rates.

ETF.com: Turning to a key overseas market, I want to get your take on China. The Chinese yuan continues to decline, and we hear about capital continuing to flow out of the country. Are you concerned about that?

Jacobsen: I'm not that concerned about it because I think the People's Bank of China has enough resources at its disposal to manage an orderly depreciation of the yuan, and an orderly outflow of capital. I’d be very concerned if we woke up one morning and they allowed the yuan to depreciate significantly. But so far, they've been managing it in a rather orderly fashion.

What I like is that in the GDP numbers, we saw an improvement in the tertiary sector growth. The tertiary sector is just mainly services.
China’s slowly trying to transition away from that export-led growth to domestic-led growth, and away from manufacturing and construction toward services. It's going to be a very slow process, but I think it's one they're going to be able to manage.

Contact Sumit Roy at [email protected].