Many of the themes and trends we were seeing at the end of the third quarter still hold true till year-end--namely, the market's laser-like focus on Europe; continued undervaluation in economically sensitive sectors such as industrials, basic materials, energy, and financial services; and reasonably strong numbers coming out of U.S. corporations.
We sense the beginnings of a shift under the surface, and we now have a decidedly optimistic outlook for the market in 2012. While the global economy will certainly continue to struggle for growth, well-positioned companies with little to no debt on their balance sheets should benefit from growing pockets of strength.
In the third quarter, my colleague Erik Kobayashi-Solomon opined that we have a long way to go before we see the end of deleveraging, and I couldn't agree more. This is certainly a meaningful headwind when it comes to economic growth, and as our director of economic analysis Bob Johnson points out, this recovery will be a bumpy one with many fits and starts.
In fact, there's no shortage of bad news out there: Demand from China could falter. Austerity measures could sap any remaining consumer demand in Europe. The European Union could fail. These are all huge concerns, and stack up to a lot of good reasons to be bearish. So why do we expect 2012 to witness a meaningful rally in the market?
First, we think pent-up demand for hard goods is starting to take off in the U.S., as evidenced by strong growth in sales of cars and TVs during last year end, albeit at the expense of demand for services. We have been commenting for more than a year that consumers cannot put off purchases such as cars and other hard goods indefinitely, and I think we all can agree that consumers cannot easily put off services like haircuts for long (at least we hope not!). While we're not calling for a huge return to growth in services, we think demand for hard goods will continue to benefit the U.S. economy.
Second, as my colleague Erik Kobayashi-Solomon commented last quarter, low leverage and strong profits leave U.S. corporations in an enviable position. In fact, U.S. company balance sheets are flush with a record $2 trillion-plus in cash, and profit margins are at or near all-time highs. Couple that with the undemanding multiples for investing in these firms lately, and we see some great opportunities out there. So even if the economy is not off to the races, we think the stock market can do well in 2012.
We're finding compelling investment ideas in several sectors, including some that are sensitive to a recovery in the U.S. economy and will therefore perform particularly well if the economy improves faster than we (or the market) expect, as well as wide moat businesses with strong balance sheets, good dividend yields, and undemanding valuations.
For economically sensitive sectors, including basic materials and energy, we think the market is particularly concerned about weakening demand from China affecting these stocks, but we see some opportunities even after taking that into consideration.
Heather Brilliant, CFA, is the vice president of Global Equity and Credit Research at Morningstar.
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