J.P. Morgan Is No. 1 in U.S. Equity Research

Until markets stabilize, U.S. money managers will rely heavily on sell-side research for insight and information on the economic landscape.

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AART 2012 The All-America Research Team
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Talk about mixed signals. Stock markets soared last month after Federal Reserve Board chairman Ben Bernanke introduced an open-ended third round of quantitative easing, in which the Fed pledged to buy $40 billion in agency mortgage-backed securities each month until the U.S. unemployment picture improves. The Dow Jones Industrial Average jumped more than 200 points on the day of the announcement, the Standard & Poor’s 500 index shot to its highest level in five years, and the Nasdaq Composite Index saw its best close since November 2000.

By the end of the month, however, the rally had fizzled. September’s final days saw stocks sustain their worst weekly declines in months, dragged down by disappointing news: The Bureau of Economic Analysis reported that the U.S. economy grew at an annualized rate of only 1.3 percent in the second quarter, down from the agency’s earlier estimate of 1.7 percent. The Institute for Supply Management–Chicago’s business barometer logged its first monthly decline since 2009, signaling a slowdown in regional manufacturing. And Peoria, Illinois–based heavy-machinery manufacturer Caterpillar, a bellwether for global economic growth, slashed its guidance — for 2015.

But consumer confidence unexpectedly surged, reaching its highest level since February, according to the Conference Board. Just one month earlier the New York–based data analytics firm’s consumer confidence index had sunk to its lowest point of the year.

With such volatile economic indicators, it’s hardly surprising that many investors have adopted a wait-and-see attitude. “Equity trading volumes are being constrained by a combination of factors that all share a single symptom: uncertainty,” explains Stephen Penwell, director of U.S. equity research at Morgan Stanley. He cites a number of issues — at home and abroad — that are weighing on portfolio managers’ minds. Domestic concerns include next month’s presidential and congressional elections, the state of the economy and the so-called fiscal cliff of some $700 billion in spending cuts and tax increases set to take effect after year-end. Foreign worries include the slowdown in China’s real gross domestic product growth and Europe’s ongoing sovereign debt crisis.

Winners in
the SpotlightTen of the top-ranked analysts on this year’s All-America Research Team are featured in the photographs below. Click on one of the images to learn more about that analyst.
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“Investors can’t have real conviction about 2013 or 2014 earnings, and they have an even harder time trying to figure out what kind of multiple to put on those earnings,” Penwell says. “Thus a lot of clients and a lot of clients’ cash are sitting on the sidelines, waiting for things to clearly improve or clearly get worse.”

When will that be? “Unfortunately, our view is that the uncertainties will not be solved just by either a turn of the calendar year or just by clarity of the election results,” he notes.

“Equity sentiment is currently at 27-year lows, creating the S&P 500’s widest discount to bonds that we have seen in the history of our data,” adds Brett Hodess, head of Americas equity research at Bank of America Merrill Lynch. “A turnaround will take more than continued dovish comments from the Fed; it will take a rise in confidence regarding continued earnings growth.”

Such reassurance may be in short supply these days — but more is coming, according to Noelle Grainger, Hodess’s counterpart at J.P. Morgan. “Don’t fight the Fed,” she quips. “We believe that the recent strength in the equity markets has legs, as the policy response to sluggish global economies has been stronger than expected. The macro picture appears set to turn more positive as the Fed’s quantitative easing is added to further Chinese stimulus and an improvement in financial conditions in Europe.”

One thing is certain: Until markets stabilize, money managers will rely heavily on sell-side research for insight and information on the ever-changing economic landscape. The firm that does the best job of providing the guidance that investors demand is J.P. Morgan, which for a third straight year leads the All-America Research Team, Institutional Investor’s annual ranking of the U.S.’s most highly valued equity analysts. The bank adds three positions, for a total of 43, and widens its lead over second-place Barclays, which returns with 39 positions. BofA Merrill, which tied with Barclays last year, slips to third after losing five spots, leaving it with 34. Morgan Stanley and Deutsche Bank Securities leap to fourth and fifth place, respectively, after picking up seven positions each. The former, with 33 total, rises from No. 6; the latter, with 32, bolts from eighth place. Survey results reflect the opinions of nearly 3,300 individuals at some 950 buy-side institutions that manage an estimated $9.93 trillion in U.S. equities, or 77.4 percent of the $12.83 trillion market capitalization of the MSCI U.S. index at the time of polling.

J.P. Morgan anticipates what it calls a melt-up ahead of the elections, Grainger says, based on further global economic stabilization, accommodative central bankers, strong relative-value arguments and “underinvestment by active managers and hedge funds, resulting in continued beta chase.”

Last month the firm’s chief U.S. equity strategist, Thomas Lee, raised his short-term target for the S&P 500 by 20 points, expecting the benchmark to reach 1,495 by November 6. (The index stood at 1,440.67 at the end of September.) “Following Election Day, he sees the risk of markets drifting lower into year-end if President Obama is reelected, which is his base case, and thus he maintains a 1,430 year-end target,” Grainger says. “We think that investors are likely to respond more positively to a win by [Republican challenger Mitt] Romney, and we see upside well beyond our 1,430 target — toward 1,500 to 1,550 — in the event of a Romney win.”

With many polls showing the candidates within a few percentage points of each other — well within each poll’s margin of error — predicting the outcome with any degree of conviction is all but impossible. And the winner may not even matter all that much. “To most investors it’s not about the person or the party but rather the policies,” says Steven Pollard, Deutsche Bank’s director of U.S. equity research. “Many will have views on how investor sentiment will shift with an Obama victory or a Romney victory, but we think three things are important: getting clarity, addressing the deficit and achieving compromise.”

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Left to right: Meredith Adler (Barclays); Jeffrey deGraaf (Renaissance Macro Research);
Charles Grom (Deutsche Bank Securities)

Once the results are in, he adds, dealing with the deficit will take center stage. “Clearly, the parties have differing views on how best to do this, but since neither party will likely control the presidency and both houses, we expect there will be a compromise to get a deal done,” Pollard says.

Or the situation could worsen given the increasing polarization of the parties, according to BofA Merrill’s Hodess. “Neither party appears positioned to take the 60-seat Senate majority required to block a filibuster, which could increase the difficulty for the majority party to push legislation through,” he says. “If one party can achieve veto-proof majorities, there may be a higher chance that Congress would stop kicking the can down the road — which is at least a start.”

Research directors hold out little hope that policymakers will address fiscal-cliff issues ahead of the election — and some have developed models that assume the U.S. will tumble over the precipice. “Our analysis suggests a 15 percent chance of actually falling off the fiscal cliff — that is, expiring tax provisions plus sequestration push the U.S. economy into recession in the first half of next year,” says Grainger, noting that it could take up to six months for legislators to come to terms, a delay that would result in a weaker second-half bounce and full-year growth of only 0.2 percent. “Interestingly, we think that the likelihood is similar regardless of who takes the White House. Of course, this is an adverse scenario for risky assets, and we see the downside for the S&P 500 at around 1,100.”

A more likely scenario, to which the J.P. Morgan team has assigned a 65 to 70 percent probability, is that the lame-duck Congress will grant itself a six-month extension to come to terms with spending cuts and tax hikes. “In this situation we would look for market weakness as investors worry about an impasse, with an anticipated S&P low of 1,300 to 1,350,” Grainger says. The analysts believe there is no more than a 20 percent chance that the current Congress will reach a deficit reduction agreement.

Economists at BofA Merrill have formulated a model that assumes such issues as the alternative minimum tax, physician reimbursement rates under Medicare and “the 50 or so tax breaks that are patched every year all will be extended for another year,” Hodess says. “In contrast, the payroll tax cut, extended unemployment benefits and some smaller and/or less contentious items will likely be allowed to expire — and some, but not all, of the discretionary cuts under the debt ceiling agreement will likely be implemented.”

Deutsche Bank’s Pollard believes there is cause for optimism. “We do not think that the budget impasse will be broken before the election, but our baseline view is that an agreement will be reached,” he maintains. “Despite their differing views, the two parties clearly have some common ground to build upon and reach an agreement.”

In the meantime, savvy investors can turn uncertainty to their advantage, according to Christopher Senyek, who captures first place in Accounting & Tax Policy for a fourth consecutive year. The Wolfe Trahan & Co. analyst predicts that the lame-duck session of Congress will reach some sort of deal to extend current tax rates for at least a few months and possibly for two years. But many companies won’t wait for Congress to act and instead will announce special dividends before the end of December to lock in current tax rates.

“We’re bulls on the structural case for dividend investing and expect more companies to initiate dividends and increase payouts once tax policy uncertainty wanes at the end of this year,” Senyek explains. “Historically, we’ve found that the share prices of companies initiating dividends and increasing dividends have provided material total returns and generated overall stock market outperformance.”

Sanjay Sakhrani, who debuted as a runner-up in Consumer Finance in 2011 and vaults to the top of the sector this year, also believes that now is a good time to buy, albeit for a different reason. “Valuations support an overweight bias for most of the companies we follow in the cards and payments industry,” the Keefe, Bruyette & Woods analyst contends. “Despite the weak macro backdrop, companies in our coverage universe have seen decent growth, which is certainly a challenge to find in the broader financial services industry.”

Sakhrani cites several reasons for this relative outperformance. “The protracted recession flushed out much of the adverse selection in card portfolios, and the composition today is skewed toward consumers with stronger credit profiles,” he says. Plus, “companies we follow are taking market share from weaker financial services players, and their capital levels are very strong, so they are in a position to be relatively more aggressive toward growth and/or capital management.”

As for the election, Sakhrani doesn’t believe it will have much of an impact on his sector. More worrisome is the fiscal cliff, especially with the holiday shopping season drawing near. “We believe there could be an implication to spending, particularly among moreaffluent, higher-income-generating consumers, who have been a large contributor to consumer spending growth,” he says.

All-America Research Team Hall of Famer Meredith Adler, who takes the top spot in Retailing/Food & Drug Chains for an 11th consecutive year, says it is important to note that wealth distinction. “‘The consumer’ is not just one group but consists of multiple groups — some of which are still struggling financially,” she says. “About 20 percent of U.S. households receive government support to buy food. In part that’s because the eligibility requirements have been lowered, but mostly it reflects great need by many families.”

Seasonal consumption by people in this group is likely to be limited despite the recent uptick in overall consumer confidence, the Barclays researcher observes; for others the higher level of optimism “is a positive signal for holiday spending — although what we have seen in the past year or so is that consumers pick the times when they want to spend, so sales are volatile from week to week.”

Most of the companies that Adler covers — drugstores, supermarkets and small-box retailers — serve all demographic groups, but many of the outlets are located in areas where income is still depressed, so “they will not see a recovery this holiday,” she says. “We have recommended some of these companies — dollar stores, particularly — because they have stable earnings and cash flow patterns as well as continuing square-footage growth.” However, she advises caution. “Dollar stores are still a relatively immature concept,” she explains. “For investors who want more beta, my stocks are generally not a good choice.”

Deutsche Bank’s Charles Grom, a runner-up in Retailing/Food & Drug Chains and the No. 1 analyst in Retailing/Broadlines & Department Stores, says money managers’ paramount concern should be to align themselves with retailers that have structurally stronger business models and those that operate in sectors with favorable headwinds.

“I do believe that most consumers are feeling better about their personal household situations — perhaps better today than at any point in the past few years,” he says. “The U.S. consumer is poised for continued momentum, particularly ahead of the all-important holiday season, when many retailers generate more than 50 percent of their annual sales.”

Based on recent brisk back-to-school revenues — there is a 90 percent correlation between the two shopping seasons, Grom says — “we would expect holiday sales to rise 3 to 5 percent over last year, and potentially better if today’s housing market rebound continues.”

Many economic observers believe it will. “Clearly, the consensus in the market is that QE3 is constructive for risk assets, and the MBS purchases will support a recovery in the housing market,” observes Deutsche’s Pollard. “Confidence and conviction in the recovery take time, and given how deep this recession was and how tepid the recovery has been, it is playing out rather slowly.”

Give it a couple of years, says BofA Merrill’s Hodess. “Many commentators are treating the Fed’s new policy as just another quantitative easing — QE3. We disagree,” he says. “We think this is QE3, QE4 and perhaps QE5 combined. The Fed has promised to continue buying assets until there is a substantial improvement in the labor market. In our view, this means until full employment is on the horizon. Given our weak growth forecast, we estimate that implies a two-year buying program.”

But patience will be rewarded, according to J.P. Morgan’s Grainger. “We are likely at the front end of a three- to five-year up-cycle in residential construction, with an associated investment opportunity in the U.S. housing food chain that sees these stocks gaining 30 to 200 percent relative to the S&P 500,” she says. • •

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