Bob Doll: Moving from recovery to expansion

Bob Doll is vice chairman and chief equity strategist for fundamental equities at BlackRock Inc. What is your outlook for the economy in the second half? Where do you see the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite Index finishing the year? Also, what is your outlook on interest rates? We have been saying for some time that we believe the U.S. and global economies would be progressing through a subpar recovery in 2010, marked by fits and starts along the way. Although it hasn't been officially declared over yet, we believe the recession in the United States ended in the summer of 2009. The economy, however, is only now beginning to experience a self-sustaining revival in confidence and spending. While the recovery is still somewhat fragile and the economy remains subject to potential shocks, improving corporate earnings, low interest rates, increasing business and consumer confidence, as well as a labor market that is beginning to turn more positive, should be enough to propel the economy from recovery to expansion during the second half of the year. From an interest rate perspective, we believe it is likely that rates will rise over the coming years as the macro backdrop gradually shifts from one being dominated by deflation to one being driven by potential inflation. Shorter-term, however, the timing is somewhat uncertain. Before the sovereign-debt crisis emerged in Europe, we expected that the Federal Reserve would soon signal that it was nearing a change in its forecast, paving the way for an increase in interest rates by the end of the year. That forecast is now looking more doubtful, implying that the Fed is likely to keep rates on hold for a bit longer than we previously believed. Regarding equity markets, given the sharpness of recent trading swings, we expect that many investors will continue to approach the markets with caution. However, should the labor market recovery continue, as we expect it will, the backdrop of strengthening corporate profits and a recovering economy should push equity prices higher — although it will take some patience to get there. Our year-end forecast for the S&P 500 is 1,200-1,250, with commensurate increases in the other broad averages. What worries you most about the markets and the economy over the remainder of the year? We see two key risks that could derail the current cyclical bull market. The first would be a significant setback in economic activity that interrupts the growth in corporate revenue and earnings. The second would be that the combination of tepid economic growth, structural head winds in the credit market and tremendous slack in the labor market [and in the economy as a whole] that persists or is exacerbated to the point at which deflation is a conceivable prospect. Which areas of the equities market look attractive to you? On the whole, continued improvement in the economy, combined with still-low interest rates and improving corporate profits, represents a “sweet spot” of sorts for risk assets. As such, we think it makes sense for investors to continue overweighting equities, with a particular focus on higher-quality investments. Regionally, we favor U.S. stocks over other developed markets, since the economic recovery in the United States has taken root more firmly. We also continue to like emerging-markets economies and view U.S. multinationals as the best way to play them. From a sector perspective, we believe a balanced portfolio is prudent — namely, one that contains exposure to global cyclicals such as industrials, materials and energy, as well as to more defensive areas like health care and telecommunications. What one investment-related suggestion would you make to financial advisers? Amid the current backdrop of slow but positive economic growth, we continue to advocate a focus on high-quality companies, specifically in the United States. In our view, these companies represent potentially lower risk and are better-positioned to outperform, relative to their low-quality peers. By our definition, quality companies are those that enjoy a strong brand, intellectual property or business franchise, a geographically diverse footprint and a history of generating stable and persistent earnings in all market cycles. These traits are reflected in financial metrics such as healthy balance sheets, good free cash flow, high returns on equity and low debt levels.