- The Washington Times - Thursday, September 28, 2006

Wall Street predicts you are going to fall in love with large-cap stocks all over again. Strategists are upping the allocation of stocks in their model portfolios and increasing their target prices for large-cap indexes.

But a question lingers: If 17 quarters of double-digit earnings growth haven’t sent large-cap stocks through the stratosphere, what will happen if companies stop booking record profits?

The Dow Jones Industrial Average is advancing toward its record high, reached in January 2000. The Standard & Poor’s 500 Index is also flirting with its high; it’s up 8.34 percent for the year, a nice return, but on the other hand, you can earn 5 percent interest nearly risk free on large savings accounts.

“Large-caps really have underperformed, even this year,” said Brian Gendreau, investment strategist for ING Investment Management. “Pretty much every market in the world has done better than U.S. large caps.”

He has a point: Foreign stocks as measured by the broad MSCI EAFE Index are up about 14 percent for the year, as are Hong Kong stocks, while stocks in the Eurozone are up nearly 21 percent, with strong performances in Spain, the Netherlands, France and Britain.

In the United States, by contrast, large-cap stocks, until very recently, seemingly could do no right. When they meet or beat earnings expectations, the market yawns. When they miss earnings expectations, investors pummel them.

“People are focused on where we are in the [economic] cycle,” Mr. Gendreau said. “Profits relative to gross domestic product are at an all-time high. People think we’re at the peak of a cycle. It seems that what’s happened is that quarter after quarter, earnings have come in higher than expected and people have said, ‘That’s the peak.’”

Some strategists say it’s time to break that habit. The forward price-to-earnings ratio of the Standard & Poor’s 500, a common way of valuing using their expected earnings, is near 14, which is cheap by historic standards. Stocks also have lower valuations than other investments, such as Treasury bonds and real estate.

That has stoked some enthusiasm about stocks.

“I believe that stocks offer very good expected net returns versus their own historical averages and compelling value versus the two big U.S. alternatives besides cash, bonds and real estate,” wrote Edward Keon, Prudential Equity Group’s chief investment strategist.

Mr. Keon recommended a moderately aggressive investor who usually has a portfolio of 60 percent stocks and 40 percent bonds switch their allocation to 90 percent stocks and 10 percent cash.

“Some time in the not-too-distant future individual investors will recognize the value represented by equities and start to buy large-cap stock funds again as they have not so far this century,” he wrote. “When these fund purchases will begin I do not know, and I admit my bullish call will probably not work if investors stay on the sidelines, but valuation, a mediocre timing tool, has always been a great investment tool and I think it will be so now.”

Mr. Keon predicts the S&P; 500 will hit 1,600 by 2007.

It’s worth noting Mr. Keon had a similarly bullish outlook on stocks at the end of 2005, when he recommended investors keep 100 percent of their portfolios in stocks.

“Stocks are incredibly cheap at this time,” he wrote in October 2005. “We expect lower energy costs and lower inflation with a few months. With low interest rates and not many other strong investment choices, now is the time to buy equities.”

His timing was off then: Interest rates kept rising, energy costs did, too, and the broad indexes ended 2005 little changed. Keon dropped his 100 percent allocation down to 55 percent in February.

At the moment, he is far from the only bull. Tobias Levkovich, Citigroup’s chief equities strategist, set a 2007 target of 1,500 for the S&P; 500 and 12,750 for the Dow.

“I haven’t seen any research by any sell-side analyst that says large caps are not going to do well going forward,” ING’s Mr. Gendreau said. “We and they have been wrong for a long time. I wouldn’t want to throw in the towel now.”

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