With all signs pointing to a classic rally, confidence is building that we are out of the woods. But industry experts reveal what we still need to look out for, and point to opportunities in the global and energy sectors.

A CLEAR AND CLASSIC RALLY, From the Investment Committee at ICON Advisers

The stock rally continued in September, and we believe conditions support a continuing rally over the long term. Stock prices have moved much higher, but underlying intrinsic value, as calculated using ICON’s proprietary methodology, has increased. In ICON terminology, prices have not caught the upwardly moving valuations.

From our point of view, the current rally is classic and obvious. First, we believe the interest rate environment is supportive. The yield on the 10-year Treasury bond has been in a level trading range for many months. Yields on corporate bonds, by contrast, have generally been dropping. In combination, these two conditions have contributed to rising stock valuations. In addition, corporate earnings are contributing to higher valuations. As we bring 2009 and estimated 2010 earnings into our valuation equation and drop off old, stale earnings, we see a modest boost to value. Despite the nice advance in stock prices off the March 2009 low, we still measure the broad market to be about 10% below our estimate of intrinsic value. In addition, there are still extremely high levels of cash on the sidelines (as measured by assets of money market mutual funds). All together, these conditions lend support to our determination that this is a “classic” rally.

From its peak in late 2007, the stock market dropped to its ultimate low in three phases. The first phase was marked by a gradual decline of about a year. Phase two was a sharp, sudden drop driven by the Lehman Brothers bankruptcy in early October 2008. The third phase saw the market drift lower as economists struggled to find a solution that could potentially lead to an economic recovery. So far, the market has recovered ground lost during the third phase. We anticipate it will recover losses from the first two phases over the next two years. It will not necessarily be a smooth recovery, as news events can make the potential ascent a bumpy ride at times. Nonetheless, we believe the fundamentals are in place for higher stock valuations and, further, that stock prices will try to keep pace and advance along with these higher valuations.   

AUSTRALIA’S RATE HIKE POINTS TO GLOBAL RECOVERY from Bob Doll, vice chairman and global chief investment officer of equities at BlackRock

Markets rallied last week in response to some positive economic news, some strong corporate earnings reports and the Reserve Bank of Australia’s decision to hike interest rates. For the week, the Dow Jones Industrial Average rose 4.0% to 9,865, the S&P 500 Index advanced 4.5% to 1,071 and the Nasdaq Composite climbed 4.4% to 2,139. September’s Institute for Supply Management’s Non-Manufacturing survey pointed to an expansion for the first time since the credit crisis began. On the corporate earnings front, preliminary reports are suggesting that third-quarter earnings may be stronger than expected. From an interest rate perspective, the big news last week was the 25-basis-point rate hike that took place in Australia, the first such move among G-20 countries in the current cycle. Australia has been experiencing a much different environment than most other industrialized countries: Its stock market has advanced nearly 100% since the bottom, home prices have been rising and Australia has largely avoided the effects of the global recession. Its move to raise rates was generally perceived as a confirmation that the global economy is moving into a recovery phase.

Understandably, there has been a great deal of focus on the state of the consumer, with concerns focusing on high debt levels and an inability to increase spending. The case is almost exactly the opposite when it comes to non-financial corporations, which are emerging from the recession with strong balance sheets, are generally in sound financial shape and are positioned to take advantage of economic growth. We believe the health of these companies will act as an important tailwind for the overall economy. On the other side of the equation, one concern we do have is the state of the federal budget. The Treasury Department is likely to soon report a $1.4 trillion deficit for the fiscal year that just ended on September 30. Unfortunately, deficit levels are worsening. The combination of flat-to-down tax revenues and increased spending levels is likely to keep the deficit above the $1.5 trillion mark for fiscal year 2010.

From a market perspective, market momentum has certainly been helped by the growing perception that the economy is getting back on track. Many remain concerned that the strong run-up in prices means that we are overdue for a correction. While we agree that corrective action could happen at any point and are aware of the long-term secular pressures, we also would reiterate that the flow of cash back into the markets, an equity-friendly macroeconomic backdrop and an encouraging earnings landscape all suggest markets will continue to grind higher.

AN OPPORTUNITY TO OVERWEIGHT ENERGY, From Jeffrey M. Jacobe, director of investments, and S.E. Cody Dick, research analyst, at Fayez Sarofim & Co.

Energy remains an attractive and critical industry from a secular perspective. The challenges of discovering, developing and delivering various sources of energy to end-users continue to grow in complexity across geographic, geologic and geopolitical landscapes. The vital issues for investors to understand are:

1) Energy consumption will rise with population growth and living standards,
2) Access, technology and capital are the key drivers of the energy industry,
3) The existing production base faces accelerating decline rates,
4) Alternatives do not have the scale to replace hydrocarbons in the intermediate term and,
5) Global energy is underrepresented in the equity markets and could gain share within the typical diversified portfolio.

There is a prevalent theory that oil production may have peaked. But over the past 40 years mankind has consumed nearly twice the world’s known oil reserves in 1970. Today, proven oil reserves are nearly double what they were estimated to be in 1970. We believe the challenges in supplying sufficient quantities of energy, let alone clean energy, to the world’s population are significant and not well understood. This lack of understanding provides an opportunity to selectively overweight the energy sector in a diversified portfolio. In addition, we believe global energy is severely underrepresented in the average investment portfolio. Much of the industry’s value is held by governments and unavailable to private investors. In the U.S., most domestic indices exclude roughly $1 trillion of market value represented by large energy companies.

Currently, we balance the risk of an overweight energy position by owning large integrated oils. These companies consistently bring capital, technology and management expertise to global markets for crude oil and low-cost natural gas. They generally maintain conservative balance sheets and offer superior returns on capital over the cyclical ups and downs common in the energy industry. The integrated oils have invested heavily in projects that offer longer and flatter production profiles and the generation of significant free cash flow. Over long periods of time, the integrated oils have demonstrated above average returns with the benefit of a low correlation with the broader market.

REPORT CALENDAR

Tuesday, Oct. 13
ICSC-Goldman Store Sales
Redbook, week ending Oct. 10
Federal Reserve Vice Chair Donald Kohn invited to address the NABE (National Association for Business Economics) annual meeting in St. Louis.
4-Week Bill Announcement
3-Month Bill Auction
6-Month Auction
New York Federal Reserve Bank President William Dudley speaks to the Institute for International Bankers.
Treasury Budget, September

Wednesday, Oct. 14
MBA Purchase Applications, week ending Oct. 9
Retail Sales, September
Import and Export Prices, September
Business Inventories, August
4-Week Bill Auction

Thursday, Oct. 15
Consumer Price Index, September
Empire State Mfg Survey, October
Jobless Claims, week ending Oct. 10
Philadelphia Fed Survey, October
EIA Natural Gas Report, week ending Oct. 9
EIA Petroleum Status Report, week ending Oct. 9
3-Month Bill Announcement
6-Month Bill Announcement
52-Week Bill Announcement
Fed Balance Sheet, week ending Oct. 14
Money Supply, week ending Oct. 5

Friday, Oct. 16
Treasury International Capital, August
Industrial Production, September
Consumer Sentiment, October
Dallas Federal Reserve Bank President Richard Fisher delivers keynote address at conference co-sponsored by Southern Methodist University’s Cox School of Business in Dallas