US stocks outperform US bonds

The US economy got off to a very weak start in 2015, but economic data are improving recently. Our US Economics team forecasts GDP growth to accelerate to a 3.2% pace in the second half of the year. We see limited impact on the US economy from the troubles in Greece and China. The US has small trade and financial linkages with Greece, so Greece matters only if it damages the rest of Europe or causes a systemic crisis in capital markets. 

BofA Merrill Lynch notes:

We forecasted modest market gains, with US stocks slightly outperforming bonds. So far, we have been correct in forecasting that US returns would be "sheepishly" calm. Through July 10, the YTD return on the S&P 500 has been +2.0%, while the return on our broad market bond index (US00) has been -0.4%. 

We believe those risks are remote. The European economy is now on better footing, European banks hold little Greek debt, and the ECB now has QE in place to be able to respond to a crisis. For more on China. We continue to see a low return environment in the US in the second half of the year, with stocks outperforming bonds. With the improving economic outlook, our economists expect the Fed to begin raising rates in September, which should pose challenges for bonds. 

We believe that this improving economic backdrop, along with rising earnings estimate revision ratios, will provide a tailwind for stocks. However, the present elevated valuations will likely limit the upside. In our view, investors may need to be even more selective, and employ tactical portfolio rebalancing techniques in order to achieve desired returns. The three-month EPS estimate revision ratio improved for the third straight month in June, as analysts have slowed their pace of estimate cuts, according to US Equity Strategist Savita Subramanian. 

The revision ratio rose to 0.84, which is the highest since September 2014, and up significantly from 0.48 in March. This could be a signal that the worst of the EPS cuts for the S&P 500 are behind us. While the earnings backdrop is beginning to improve, valuations for US equities remain a concern. Valuations on many different metrics are above their long-term averages; however, we would argue that US stocks are still far from bubble territory.