Bank of America Merrill Lynch: Energy is the Play to Make Now

With the first half of 2015 officially in the record books, Bank of America Merrill-Lynch on Tuesday hosted a mid-year check-up to update investors about market trends and forecasts heading into the second half of the year.

After six frenetic months that included a significant slowdown in economic growth in the first-quarter, anticipation building over when the Federal Reserve will most likely begin to hike short-term interest rates, and a market that only really knows an upward trajectory – analysts at the investment bank expect the second half of 2015 to be relatively smooth sailing.

1. U-Turn: Wall Street Will Embrace Rate Hikes

Over the past 12 months, the S&P 500 has moved steadily higher, climbing past 2100 from 1962 a year ago. Looking forward over the next six months, as Savita Subramanian, Merrill’s head of U.S. equity and quantitative strategy, put it  be “bullish, but not uber bullish” on U.S. equity markets. The house view is for an end to the year at 2200 on the S&P – the lowest upside built into the bank’s returns forecast since 2011.

“We’re seven years into a fairly strong bull market in U.S. equities. Not surprisingly, valuations today are no longer as compelling as they were a couple of years ago,” Subramanian said. “While we still expect upside, the returns could be much narrower than in prior years.”

There are several factors to the forecast at play.

On the bearish side: Earnings growth will most likely, Merrill predicts, be challenged by the persisting stronger U.S. dollar, and lower oil prices, which are generally bullish for the economy overall, but a drag on S&P 500 corporate earnings.

On the bullish side: Rate hikes from the Fed. You read it right – good news looks to be good news again for Wall Street. This comes after months of taper tantrums, and significant selloffs on even the slightest hint at higher rates on the long-term horizon. But Subramanian said Wall Street’s finally coming around to seeing the upside potential. She added that optimism is likely to play out with companies decreasing focus on stock buybacks, and turning attention to ramping up capex spending.

“A Fed rate hike this year would actually be a positive sign of confidence that the Fed is at a point where they can liftoff from the zero bound,” she said. “More importantly, we’re still at a point where equity allocations are fairly light, and sentiment on U.S. stocks is fairly tepid given that we’ve had a pretty significant run in the stock market.”

She pointed to the above chart which shows that the average allocation Wall Street strategists recommend putting in an overall portfolio is about 50% toward U.S. stocks. The benchmark over time has hovered around 60% - 65% for U.S. stocks – which suggests there’s yet more room for the bull market to run.

2. When it Comes to Energy: Buy, Buy, Buy

Global oil prices dropped to multi-year lows last summer, and have seen limited upward momentum since they bottomed out near $50 a barrel earlier this year. With debate in the industry centered on which nation or group should cut back on their production, global supplies remain at significantly high levels.

While that’s a concern for many shops on Wall Street, for Merrill, there’s significant upside to investing in energy stocks. In fact, the bank is overweight the sector.

“Energy is more hated than it’s ever been in the history of our data,” Subramanian said. “Mutual funds and the active community has de-rated the sector and lowered allocation to energy to the lowest relative weight. We’re at a point now where downside risk is limited.”

She added that the price-to-book multiples are hovering at the lowest levels in the last 30 years. The last time it was at that level was in 1986.

“If you bought then you would have made 30 percentage points above market value,” she said. In addition to the energy sector, Merrill is also overweight stocks that large-cap, medium-yield, dividend growth stocks that have lots of international exposure. Those include information technology, and industrials. The bank sees the most risk is utilities and telecom, as well as consumer discretionary, which tends to “chronically underperform” when the Fed begins to tighten.

3. No More Downward Revisions to Earnings Forecasts

At face value, first-quarter earnings results came in pretty positive when put in the context of the severe slowdown in economic growth. But pull back the layers, and the reason many firms beat was due to downward revisions in their forecasts, which made a decent earnings beat possible.

Subramanian on Tuesday said those overly pessimistic downside revisions that lead to overly optimistic beats should be coming to an end after the second quarter. She calls this year the year of lost earnings as the team forecasts flat earnings growth for S&P 500 companies this year.

“The good news is that analysts have finally stopped slashing their numbers,” she said. “For once, we’ll have more reasonable expectations. Consensus expectations seem to be reasonable at this point.”

4. Economy Will Brush Off 1Q Weakness

Ethan Harris, BAML’s co-head of global economic research, said, like many on Wall Street, he and his team are increasingly skeptical about the weakness from the first quarter. He said it’s most likely attributed to a strong dollar and temporary factors including the West Coast port strike, severe winter weather, and other various seasonal problems.

Instead of focusing on GDP as an indicator of the U.S. economy’s health, Harris recommended looking to non-farm payrolls.

“GDP flies all over the place,” he noted. “There have been three or four negative quarters in this recovery while payrolls are creeping higher. Payroll numbers are telling the truth.”

To that point, he said the economy has reached the point where it’s coming out of the “funk” of little wage-negotiating power for workers, and now there’s more balance emerging.

“In this labor market, the quality of the group of people who have been discouraged and unable to work where they want is good. These are effective competitors for jobs, if the jobs are there. They act as ongoing constraint on wage growth. But we’ve reached the point where wages are increasing, happening at the very low end first at Wal-Mart, McDonald’s and so on. These are places where there has been no wage increases for years.”