‘New Mediocre’ Leaves Russell Investments Tepid on U.S. Shares

(Bloomberg) -- U.S. stocks may have rebounded from the U.K. referendum, but that doesn't make them any more of a buy than they were before they sold off.

That's according to Seattle-based Russell Investments, which says American equities are priced too high with too few prospects for earnings growth to rally much more. Other reasons for caution listed in a report distributed Wednesday include weaker job creation and fading price momentum. The firm reiterated an underweight recommendation for U.S. stocks.

“We see the new mediocre, which is a combination of lackluster global GDP growth, weak corporate earnings and expensive U.S. equity market valuations,” Paul Eitelman, investment strategist for North America, said by phone. “The net result of that is that we think medium-term expectations are likely to be subdued.”

Ahead of the second-quarter reporting season, Russell expects the backdrop for earnings to be less negative as transitory drags from low energy prices and U.S. dollar strength fade, Eitelman said. Even so, the outlook for U.S. corporate results remains “pretty lackluster,” particularly given some headwinds as the labor market tightens and wage pressures continue to gradually build, he said.

At the start of 2016, Russell strategists estimated returns from U.S. equities would be moderate, seeing low- to mid-single digit returns amid expensive valuations and the risk of the Federal Reserve tightening monetary policy. That's largely been true, with the S&P 500 Index swinging between gains and losses all year and up just 1.7 percent so far in 2016. Meanwhile, their overweight call on European shares has turned out to be less reliable with the Stoxx Europe 600 Index down 13 percent.

Earnings in the S&P 500 are forecast to fall 5.4 percent in the second quarter, the fifth straight decline, according to analyst estimates compiled by Bloomberg. The index trades for more than 19 times annual earnings, one of the highest valuations of the past 10 years.

One troubling sign: the stock and bond markets are “at odds” with each other, Eitelman said. “There's a bit of a tug of war between the equity market liking low interest rates, but those low interest rates from the bond market are reflecting some genuine pessimism about the outlook for the global economy and global growth.”

Equities and bonds surged in tandem last week as policy makers dropped hints at further stimulus following the British secession vote and suggested they'd keep interest rates lower for longer. The S&P 500 surged 3.2 percent to 2,102.95, including three consecutive daily gains of more than one percent, while Treasury rates slipped to record lows.

That doesn't necessarily suggest a recession is imminent, even though “the depth and breadth of the current earnings slump is quite rare outside of an economic recession,” the strategists wrote. Based on their models, the chances of such a downturn are “still unlikely” in the next year. By comparison, economists see a 20 percent probability of a U.S. recession within the next year -- the same reading as February, according to the median estimate of those surveyed by Bloomberg in June.

The S&P 500 slumped 5.3 percent in the two days immediately following the vote, only to recoup nearly all of those losses in the subsequent four days. Those swings triggered neither buy-the-dip nor sell-the-rally strategies for Russell Investments.

“We need to see substantial moves in either direction before gaining conviction,” the strategists wrote. “Even after the Brexit vote, it has not been of a magnitude to trigger another signal.”

To contact the reporter on this story: Anna-Louise Jackson in New York at ajackson36@bloomberg.net. To contact the editors responsible for this story: Jeremy Herron at jherron8@bloomberg.net, John Shipman, Inyoung Hwang