There is an old adage that can be very costly to ignore if you’re a fund manager: “Never bet on a weak US consumer”.
In the past few years, this has translated into: “He who bets against US equities will look like a fool”. There is no two ways about it; I have looked like (or maybe been) a fool.
But there is also another adage: “He who laughs last laughs longer”. Now let me give you the reasons that make me believe that although having looked foolish during the past year or so I am now bracing myself for a long laugh.
The framework we use when taking asset allocation decisions consists of the four following angles: valuations, technicals, marginal economic change and marginal corporate change.
There is no denying that from a technical point of view, momentum appears strong for US equities, although one may fear they are in danger of reaching over-bought levels, but the main reason for my concerns is not only the current valuation levels but also the potential economic slowdown coupled with the recent drop in earnings growth estimates.
Looking at valuations, we can only be concerned at relative expensiveness. Looking at traditional measures like price- to-earnings or price-to-book, US stocks appear to trade at a hefty premium to the rest of the world. Looking at the ratios for some of the largest components in the S&P 500 index can actually send shivers down your spine.
It is possible not to be too alarmed at the sight of such high valuation levels if you are confident of sustained, above trend economic growth in parallel with healthy corporate earnings. Sadly we don’t believe that we are heading this way.
We believe that there are a lot of threats to the seemingly unstoppable housing-led US recovery.
We might start with the recurring political pantomime and the tragi-comical lack of action taken to resolve the debt issue. The damage caused by the recent shutdown is not only bad for business sentiment and confidence, it also hurts the economy badly, the recent print in the ISM non-manufacturing dropped by 4 points, the biggest drop since the global financial crisis.
Now, looking closer at the housing sector, all is not rosy any more. House prices are up 12 per cent year-on-year but we start to see some softness in activity (housing starts/permits). Pending home sales fell 5.6 per cent month-on-month in October (and are also negative year-on-year when seasonally adjusted).
With pending home sales leading the existing home sales series, we expect to see the decline reflected in existing home sales very soon. This weakness in activity can be explained by the recent steep rate in mortgage rates.
A lot of the recovery has been generated not only directly by the increase in housing activity but also a surge in consumption triggered by the wealth effect generated by house prices rising. If this slows, or even worse stops, then the US economy is likely to slow quite significantly.