The S&P 500 index managed to break into new territory by exceeding 2,000 for the very first time during the summer.
Investors in the US stockmarket received a total return of 32.4 per cent in 2013, with 2014 providing another near 10 per cent return from the beginning of the year to the end of August.
Clearly investors are being well rewarded for their continued faith in the US stockmarket, so what is it they continue to find so attractive about US equities?
The macroeconomic performance of the US continues to improve, and is well ahead of where most commentators had assumed it would be at the beginning of the year.
Employment and wages data are improving to the point that the Federal Reserve has remained steadfast in its path towards removing quantitative easing and are hinting about raising interest rates.
While the economic improvement is welcome, it is rare that markets power ahead when policymakers begin ‘removing the punchbowl’.
An alternative explanation could be improving profitability – after all, this is what shareholders are hoping for when they invest.
Factset’s Earnings Insight Report shows that 74 per cent of companies issuing earnings guidance for Q3 2014 have given negative reviews, in effect warning analysts that profits will not be as good as expected.
The same report goes on to state that the forward price-to-earnings ratio is 15.6x, which is above the 10-year average of 14.1x. This is a market that looks pretty expensive, with a lacklustre shorter term profits outlook – hardly a combination to get investors excited. Someone must be buying, though, as the S&P 500 has made more than 20 new all-time highs year to date.
One particularly interesting piece of research we have come across was by Albert Edwards at Société Générale, who highlighted the impact of share buybacks on S&P 500 returns in Global Strategy.
The Economist has also carried an article about buybacks, which in 2013 reached $500bn (£308.1bn), almost exceeding the peak set in 2007. But why is this happening now?
We hear from many investors the refrain that companies are highly cash-generative and are being managed cautiously. An outcome of this is that companies are avoiding investment opportunities they feel are too risky and instead use their cashflow to buy their own shares.
The Albert Edwards article highlights it is not just cashflow that is being used, but additional debt is also being raised to fund even higher levels of share buybacks.
If you suspect, as we do, that buybacks have been a very strong support to the US stockmarket, then perhaps the end of quantitative easing followed by rising interest rates should be a cause for concern, as debt financing will become less attractive and buybacks will decline.
We are a long way into a cycle and this is a market that appears expensive, driven by companies which have taken on a lot of debt to buy shares that are already at record prices. What could go wrong?
Marcus Brookes is head of multi-manager at Schroders
