Three (3) Reasons Why The Recent Rally Can Continue (OEF, IOO, HDV, PFF, LQD)

Russ Koesterich: Call #1- The rally was justified – and stocks still look cheap:  Domestic stocks have now jumped around 20% from the October low, while emerging markets and European equities have jumped by approximately 25%. This is a big move, but is it justified? I believe so, and here are three reasons why:

First, and most important, a large part of the late summer sell-off was precipitated by a growing belief that the United States and the global economy were about to enter another recession. While recent economic data is still soft, it has been largely better-than-expected, including Thursday’s third quarter gross domestic product report. The data confirms my view that the economy will continue to expand, albeit at a slow pace.

Second, stocks were very cheap at the lows, and even today continue to look inexpensive, particularly relative to bonds. Globally, stocks are still trading for 13x trailing earnings, with emerging markets at a multiple closer to 11x. These valuations are still well below the long-term averages, especially when you take into account the low inflation, low interest rate environment. In other words, there is still room for some modest multiple expansion for most equity markets.

Finally, it looks like a meltdown in Europe will be avoided, at least in the near term. Investors were rightly concerned over the crisis in Europe, but last Thursday’s plan addresses some of the issues, notably a larger haircut for investors in Greek debt and a start at recapitalizing the banks. As such, it will probably help avoid a crisis and removes a big source of near-term risk.

That said, I don’t believe the plan resolves all of Europe’s longer-term problems. This plan removes the near-term threat, but it is likely that the issue will return in 2012. For now, with the economy stabilizing, valuations still cheap, and Europe’s problems temporarily moved to the side, I think stocks can move higher, and I would remain overweight equities.

For investors looking for broad equity exposure, we would continue to favor the large- and mega-cap dividend payers (potential iShares solutions: OEF, IOO, and HDV).

Call #2: Revert to neutral on REITS

I discussed underweighting this sector back in late July, believing that investors were stretching too far for income. As a result, these stocks looked too expensive relative to both financials and the broader market.

Since then, REITS have lost around 7%, underperforming the market by around 3%. As valuations have now come in significantly, I would remove the underweight and revert to a neutral stance on the REITS.

Disclosure: Author is long IOO

REIT investments are subject to changes in economic conditions, credit risk and interest rate fluctuations. There is no guarantee that dividends will be paid.

Source: Bloomberg

Written By Russ Koesterich From The iShares Blog

Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist as well as the Global Head of Investment Strategy for BlackRock Scientific Active Equities. Russ initially joined the firm (originally Barclays Global Investors) in 2005 as a Senior Portfolio Manager in the US Market Neutral Group. Prior to joining BGI, Russ managed several research groups focused on quantitative and top down strategy. Russ began his career at Instinet in New York, where he occupied several positions in research, including Director of Investment Strategy for both US and European research. In addition, Russ served as Chief North American Strategist for State Street Bank in Boston.

Russ holds a JD from Boston College Law School, an MBA from Columbia Business School, and is a holder of the CFA designation. He is also a frequent contributor to the Wall Street Journal, New York Times, Associated Press, as well as CNBC and Bloomberg Television. In 2008, Russ published “The ETF Strategist”(Portfolio Books) focusing on using exchange traded funds to manage risk and return within a portfolio.

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