While the US market appeared to stage a recovery last year and in the first quarter of this year, the S&P 500 has slipped more than 1000 points since its peak in April, amidst concerns about the European banking sector and consumer debt levels.
“This sharp decline constitutes a fairly severe correction by historical standards,” says Duilio Ramallo, fund manager of Robeco US Premium Equities Fund. “A barrage of negative news surrounding the May 6 ‘flash crash’, the debt problems of peripheral EU countries, potentially harsh reforms in the banking industry, risks of a hard landing in China, and oil pouring into the Gulf of Mexico, triggered a panicky flight from nearly all risk assets.
“Despite the downturn, we believe meaningful stock price gains can be driven by a sustained earnings recovery, which has some way to go even after the first quarter produced the best earnings reports in over 30 years, with 80 per cent of S&P 500 companies beating estimates,” he explains.
“Progressively better earnings rather than expanding price-earnings multiples are likely to be the major force pushing the market higher. PE multiple expansion usually drives gains in the market during its initial recovery from a low point; however, multiples now are likely capped by upward pressure on interest rates and growth constraints derived from debt levels, especially in the public sector,” adds Mr Ramallo. “In contrast, corporate earnings power remains solidly intact; 2010 & 2011 per share earnings in the high 70s to mid 80s readily support an S&P 500 of between 1200 and 1300, 10-15 per cent higher than today.”
Uncertain times
For many fund managers, however, the climate is less certain and easy to read than three months ago. “The big question is whether we are in a double dip or a typical mid-cycle slowdown following strong early stage recovery growth,” says Adrian Brass, fund manager of the Fidelity America fund.
“My view is the latter, that inevitably such a high growth rate could not be sustained, but I do worry about the serious structural issues across investor markets as a whole, which will constrain growth in the coming years.”
Mr Brass predicts a fall in GDP growth from 3-3.5 per cent, to 2-2.5 per cent, largely as a result of reduced government and consumer spending. However, he believes that profits will come back to normal levels in the next quarter because the US is a broad, diverse and highly flexible market, and companies can cut costs relatively easily compared with Europe, where
rationalisation is a longer process.
“Europe is further behind in its cleansing,” maintains Mr Brass. “The core issues at the heart of the crisis are the financial sector and housing, and the US is closer to sorting out these problems.”
If the recovery does stall then other factors, such as the currency, support the case for the US over European markets. “My sense is that if we are in a double dip then the US is where investors should want to be,” says Bill O’Neill, chief investment officer, EMEA Wealth Management, Merrill Lynch. “The US will outperform in currency terms because the dollar will hold up well in an environment where equities are under pressure. The US has a big weighting in consumer goods and technology stocks which are less cyclical, whereas Europe has greater exposure to materials and financials.”
The US market is neither cheap nor expensive at 13.5x , while the UK is on 11x earnings and Europe is on 10x this year’s earnings, reflecting the higher ratings in the technology sector. However if you compare the US market on a risk premium basis against Treasuries, then it continues to look cheap.
“If, on the other hand, you don’t anticipate a double dip and believe growth may accelerate, then the US is not the place to prosper,” adds Mr O’Neill. “Emerging markets and Europe will perform better because earnings momentum will be stronger. The US will lag if recovery accelerates next year.”
Historically, value funds tend to perform well after a recession and many that were positioned for recovery did well last year. The issue is whether good valuation opportunities remain.
“The case for The Bear is easy to make, with all this pessimism about the macro-economic backdrop, but investment success starts with the price you pay to buy a company and stocks have corrected throughout the summer, raising the possibility of a winning investment,” says Kevin Rendino, managing director and portfolio manager at BlackRock’s Basic Value US fund.
“At current valuations, this is the optimal point for the last 20 years in terms of the quality of companies versus the multiple investors must pay for them,” he says.
