Waiting for Uncle Sam to turn the corner

One of the most interesting developments of 2015 is how the market's enthusiasm for US equities appears to be cooling. Even the dollar's strength relative to sterling offers only a minor amount of comfort to UK-based clients who will, ultimately, be banking their returns in pounds and pence rather than nickels and dimes.

US is lagging the pack in 2015

Source: Thomson Reuters Datastream, AJ Bell Research

The reasons for the end of the affair, at least for now, appear to lie with an economic soft patch and, perhaps above all, the valuation currently attributed to American stocks. The weak first-quarter GDP number can be blamed on dollar strength, cold weather and a West Coast ports strike but only the latter really applies to the April-to-June period, which still seems likely to produce another relatively uninspiring second-quarter outcome. 

This flaccid rate of progress cannot be helping US stocks, even allowing for the support provided by the Federal Reserve’s ongoing reluctance to increase headline interest rates from the zero to 0.25% range at which they have been held for the thick end of seven years. According to research from Standard & Poor’s, US corporate earnings growth is all but zero. That is not the end of the world but it is not helpful when US stocks look at the very least fully valued, according to certain tried-and-tested valuation measures.

Valuation is never a timing tool and markets can remain expensive (or cheap) for a lot longer than anyone thinks, to crudely paraphrase John Maynard Keynes. Bulls of US equities will point to how consensus estimates call for a hockey stick recovery in American corporate profits growth from the fourth quarter onward. Bears will argue earnings estimates have been sliding for over a year, adding that analysts must be smoking something very strong to come up with such optimistic forecasts. 

We will see who is right but with the US representing around half of the global market cap the results could have profound implications for everyone.

The best performing US OEICs over the past five years

Source: Morningstar, for US Large Cap Blend Equity category. Clean funds only.
Where more than one class of fund features only the best performer is listed.

The best performing US investment trusts over the past five years

Source: Morningstar, The Association of Investment Companies, for the North American and North American Smaller Companies categories. * Share price. ** Includes performance fee

The best performing US ETFs over the past five years

Source: Morningstar, for US Large Cap Blend Equity category
Where more than one class of fund features only the best performer is listed.

Sticky spring

While many commentators continue to get excited about April’s 5.4% unemployment rate in America, the lowest rate since May 2008, leading sentiment indicators such as the manufacturing sentiment surveys and concurrent ones such as industrial output and retail sales look less compelling. This makes sense, given unemployment is a lagging indicator. 

In the end, the US economy grew by just 0.2% in the first quarter and the Atlanta Federal Reserve’s GDP now website is expecting just 0.9% in the second, as improved consumer sentiment (helped by lower oil prices) is partly offset by lower industrial activity (where industrial investment is being curbed owing to lower oil prices).

The US is battling to recapture lost economic momentum

Source: Thomson Reuters Datastream

This soft spot, whatever its causes, is starting to have an impact on US corporate earnings. According to data on Standard & Poor’s website, aggregate operating earnings per share for the S&P 500 fell by 5% in the fourth quarter of last year and probably did so in the first quarter of this one. S&P’s aggregated estimate of $25.93 a share for the first quarter puts US earnings back where they were in the first three months of 2013 – which the S&P 500 ended at 1,562 compared to its current 2,129 mark.

The good news is analysts do believe the US will recapture its mojo from the fourth quarter onwards, perhaps helped by the recent pullback in the dollar, a bounce in oil and a more confident outlook in Europe, a key trading partner as well as a rival. S&P’s data also show earnings growth is expected to rocket back into the mid-teens from the fourth quarter onwards.

Analysts expect a healthy rebound in US corporate earnings later this year

Source: Standard & Poor’s

In some ways they need to be right. Warren Buffett’s preferred market cap-to-GDP ratio and Professor Robert Shiller’s cylically adjusted price/earnings (CAPE) ratio both suggest the valuations currently attributed to US stocks look toppy in historic terms. 

Shiller’s work puts US stocks on 27 times earnings against a post-1881 average multiple of 16.

Shiller CAPE valuation analysis suggests US stocks are extremely overvalued

Source: http://www.econ.yale.edu/~shiller/data.htm

Meanwhile, America's market cap-to-GDP ratio's current mark of 133% is higher than the peaks seen in both 2000 and 2007, using the Wilshire 5000 as a benchmark.

Market cap-to-GDP ratio also looks elevated, relative to history

Source: Thomson Reuters Datastream, AJ Bell Research 

Defenders of the faith dismiss Shiller by arguing its 10-year average earnings multiple includes 2007-2009 and thus that one of the worst recessions ever seen depresses the profit figure and falsely inflates the valuation. Defenders of the faith also will point out US firms have never been more profitable. Corporate earnings to GDP stand at around 13% against a long-run average of 4.9% 

US firms have never been more profitable

Source: Thomson Reuters Datastream

This may be due to technology, improved productivity and better supply chain management. It could also be due to underinvestment, accounting shenanigans and cost cutting which ultimately proves unsustainable, at least if firms do not wish to undermine their own competitive position. The next few months could be telling. 

Currency conundrum

As a final point, it may not be a coincidence that Europe is gathering economic momentum just as the US is losing it, with the former helped by currency weakness and the latter hampered by it.

America’s headline S&P index 500 has lost some momentum...

Source: Thomson Reuters Datastream

...just as Europe’s Stoxx 600 is benefiting from currency weakness

Source: Thomson Reuters Datastream

The impact of the greenback will not go unnoticed in the Marriner S. Eccles building, as Federal Reserve Janet Yellen wrestles with whether to raise interest rates or not. A US rate hike of any kind would probably send the dollar into orbit, something that would elicit fresh squeals of discomfort from corporate America (and possibly equity investors too). This could delay any increase in US borrowing costs, especially as Japan and the Eurozone continue to push ahead with quantitative easing (QE) programmes.

In a spring research paper French investment bank Natixis even argues that the Eurozone’s economic progress is merely the result of a competitive devaluation and what it terms “stealing growth” rather than any structural improvements. The document cites weak productivity, historically low levels of research and development spending and poor overall employment levels to support its case, as well as flagging the benefit to the Eurozone of weakness in both the single currency and the oil price. If this perspective is valid, the US may well hold off from any rate hike for some time in the hope the dollar softens. 

It also helps support the case of those who believe no-one wants a strong currency and may therefore help to explain gold’s latest  little run back toward $1,230 an ounce. Perhaps investors are of the view central banks are going to let monetary policy run a lot looser for longer after all. As measured by the US-listed Market Vectors Gold Miners Exchange-Traded Fund (ETF), which comes with the ticker GXD, gold mining stocks are getting a leg up by someone after a long spell in the doldrums.

Gold and gold miners’ latest rally speaks of a further

Source: Thomson Reuters Datastream

Russ Mould
AJ Bell Investment Director