InvestmentsAug 11 2014

No sign of bull run hitting the buffers

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With US equities continuing to break all-time highs, investors are increasingly asking if value remains in the market.

While US markets are not as cheap as a couple of years ago, the market is not at extreme valuation points. Most indices and sectors are either trading at or near long-term averages, while US equities remain attractive relative to bonds.

A longstanding concern is that the valuation of small-cap stocks relative to large caps is towards the top of the historical range. After a very strong run, small caps are starting to lag.

From the lows of March 2009 to the end of June 2014, this bull market has lasted 64 months and delivered a 190 per cent price return. Yet it has not felt like a bull market to many investors, with many still climbing a wall of worry.

Longevity does not necessarily mean that the bull market is about to end. Such conclusions are usually triggered by a recession or a shock external event. The former is unlikely, while the latter is always possible. Having lived through a number of shocks in recent times, it is hard to envisage one that could trigger the end, especially when corporate fundamentals are strong.

It would not be a surprise to see a broad market correction, but it still has not happened. However, in March and April, there was a sharp intra-market rotation away from many higher growth and premium valuation names back to more defensive areas.

Though such moves are not unusual, this one was particularly rapid and severe. Even though there has been no overall market pullback, it felt somewhat like a correction for growth investors. Interestingly, some of the underperformance seen in these areas has already begun to reverse.

Many have turned their attention to what might happen to equities if the Federal Reserve begins to raise rates. When interest rates rise, it is typically because of improved economic growth – which is positive for corporate profits, improves investor sentiment and expands price/earnings (p/e) multiples.

Since the end of the recession, dividends, share buybacks and capital expenditures for S&P 500 companies have recovered nicely. Companies have been putting cash to work, but there is certainly capacity to do more of this. As business confidence improves, a further pick-up in capital spending would provide additional support for the economy.

Another consequence of improving confidence is that merger and acquisition activity has picked up, both in numbers and the value of deals. This has given a nice support to the market. Only time will tell which acquisitions prove to be a good use of shareholder capital.

After a very strong recovery from the recession, earnings growth has turned more moderate. Earnings grew roughly 6 per cent in the first quarter of the year, which was respectable given the impact of adverse weather in many parts of the US. The market as a whole is expected to deliver earnings growth of 5-10 per cent this year, which is decent at this stage of the economic cycle.

An area of particular note is the renaissance in US manufacturing. Chinese wages were 20 times lower than those in the US in 2000, but the wage gap has narrowed considerably, reducing the once-massive cost advantage of Chinese manufacturers. In addition, transportation costs have gone up pretty dramatically.

The recent boom in US energy production from shale reserves may have been the tipping point for many companies’ decision to take manufacturing back to the US. For example, petrochemical firms plan to spend $125bn (£74bn) on new projects in the coming decade – more than a 12-fold increase over the previous 10 years. This offers investment opportunities in the companies serving this build-out, as well as in providing equipment to the booming domestic energy sector.

The transportation sector has been among the first to feel the tremors. With wages now roughly on a par with China, Mexico offers the additional benefit of being right across the border from US end markets, creating opportunities for well-positioned transport firms.

Equity markets are expected to continue to deliver positive returns, but it will be more moderate than investors have been accustomed to and an increase in volatility would not be a surprise. While several headwinds exist – such as the recent change in monetary policy, existing high levels of profitability and ongoing geopolitical risks – these will be offset by the tailwinds.

Helen Ford is US equities specialist at T Rowe Price