The health of Apple, the largest constituent of the S&P 500, tells us much about US economic recovery. In asking up to $17,000 (£11,410) for its new Apple Watch, the tech giant must be confident of enough buoyant consumers willing to splash out big money on a gadget.
The question from investors’ point of view is: who is ready to call time on the equity bull market?
Having climbed close to 70% during the past three years (to 23 March), it is understandable why commentators are now widely split on the future direction of the S&P 500.
It is equally clear why investors in US funds are confused as to what really is the best way to play the market in what has so far proven to be a volatile year.
Could it be that, having had their confidence shattered by the financial crisis, investors have forgotten how to play a prolonged bull market?
Felix Wintle, manager of Neptune US Opportunities Fund, is one bullish fund manager who suggests this may be the case. He points out the S&P 500 registered 53 market highs in 2014, essentially one per week (there were 45 in 2013) as investors bought into dips.
“In bull markets, you get that continual improvement, which can sometimes look a bit foreboding for investors, but it’s not, because that’s what bull markets look like,” he says.
“There is always this assumption that bull markets are easy to navigate but actually they are not, because you are constantly questioning whether things have gone too far, too soon, and whether things are overvalued. But new highs should be embraced as part and parcel of the bull market, and that it’s a positive sign.”
Ready for rates
So what are the main candidates for halting the market rise? Fed action to raise interest rates seems the most obvious upcoming concern, as does the ongoing strength of the dollar – a headwind for exporters – and further drastic movements in commodity prices.
Still, as Wintle makes clear, a rate rise has been reasonably well telegraphed by the Federal Reserve, while market collapses and major reversals are more likely to happen when the left field happens – a ‘Black Swan’ event, if you will – rather than when change occurs that the market has already anticipated.
So what of dollar strength, the currency having reached a 12-year peak against the euro in March?
“Within the US, of those companies that have announced disappointing earnings results, almost all have highlighted the strong dollar as the main factor holding back earnings,” says Michael Stanes, investment director at Heartwood Investment Management.
“Companies with big global operations have suffered as a result of the prolonged run we have seen in the dollar dating back to the middle of 2014, which has made US firms both less competitive in terms of pricing and also less profitable as a results of earnings translations.”
Dollar headwinds
Blue chip mega-caps are likely to be the most affected by continued dollar strength, with around 45% of the S&P 500’s earnings being generated internationally. However, says Wintle, the market can treat these companies very differently.
He explains: “During the past quarter, Apple had a 500bps headwind because of the dollar, so it was majorly affected, but the stock went up on the numbers. Why? Because the fundamental performance of the company was so strong that markets see through the currency issue. However, IBM, which is less well placed, also had a currency headwind, and the stock fell on the numbers.”
He adds: “The market is rewarding companies whose underlying results are good despite the currency headwinds. Of the whole US economy, 12% is exports, so it’s not a major factor when looking at it in the round.
“Yes, a strong dollar is a drag on earnings, but it keeps commodities prices low, keeps inflation low and typically boosts the PE of the market. For an economy that is 75% consumption, low inflation is a massive boon.”
So are low commodity prices really such a good thing in the long term? Of course, the earnings of oil and oil services firms, such as ExxonMobil, are obvious casualties.
However, says Simon James, founding partner at Gore Browne Investment Management, earnings falls are deteriorating across the market, oil-related or not.
“With the big multinationals more susceptible to earnings erosion, it is reasonable to think that, with most people expecting the dollar to continue to be strong, looking at domestically focused companies is likely to be a good idea,” he says.
“While in the UK we can see that companies have generally been hiring people rather than trying to improve productivity, in the US there has always been continued focus on productivity improvements.
“Even though they may not have invested seemingly larger and larger amounts in capital investments in the past few years, it seems reasonable to assume that because of things such as Moore’s Law [an axiom of microprocessor development usually holding that processing power doubles about every 18 months, especially relative to cost or size] the impact you can make on productivity in your business for a lower price is much lower than two years ago.”
Relative to an overall neutral stance on overseas exposure, Gore Browne has had more exposure to the
US than to other markets.
However, the preferred route is through wider reaching funds, such as Fundsmith Global Equity, Scottish Mortgage Investment Trust, Murray International Trust, Jo Hambro Global Select and Worldwide Healthcare Trust.
Beyond mega-caps
If it is the mega-cap arena that faces the fiercest headwinds, does this mean investors are better off looking elsewhere?
Recent history suggests that hunting further down the cap scale is a more rewarding route into the States.
Over five years to 24 March, the IA North American Smaller Companies sector was up by 95%, versus 81% from the North America category. Over 10 years the difference is even bigger, although smaller companies clearly carry more volatility.
For Dan Harlow, portfolio manager of the Axa Framlington American Growth Fund, the latest earnings season has been kinder to more domestically oriented mid-cap names.
“In the past two-and-a-half years, we have seen a market that has been led to highs by what we characterise as bond proxies,” he says.
“In a world where interest rates and Treasury yields are low, investors have been drawn towards large caps that have brand equity, dividend yields north of 2.5% – in excess of what you get from a 10-year Treasury – and have that return profile.”
He points to a multiple expansion in utilities and consumer staples, which have moved to “a super-normal premium” to markets as those trades have become overcrowded.
Harlow’s strategy is broadening out to younger, growth-oriented businesses that have been overlooked in the past couple of years.
His preference is for a more domestically focused mid-cap bias. For example, he owns “younger and more dynamic” tech names such as Salesforce.com, rather than the likes of Apple, Microsoft or IBM.
He adds: “We have a bias towards companies that are proving out their business models in the US, and will be looking to export in due course, or those companies building sales capabilities or expanding in Asia Pacific or Europe over time. They do not have overseas earnings to the scale of the big caps, which already have a flag in most territories.”
Growth and earnings
The message from fund managers such as Harlow and Wintle is that the US is now a mid-cycle economy, with a tailwind for growth and earnings in selective sectors, which is creating the perfect environment for active stockpickers.
Of course, they would say that, given their day jobs, although they have a point given how we may now be approaching the end of an age in which markets are primarily driven by unconventional monetary policy.
“We ended QE back in October and we are clearly on the road to ending extraordinary easy monetary policy by raising rates – the US is several years ahead of the rest of the world. And as you end that period, you create winners and losers,” Wintle says.
“We intend to take advantage of this and hopefully it will be a period where it is not all about passive investing in the US, and active managers can take back some share.”
Is the party over?
Not everyone is optimistic, however.
For Tom Becket, chief investment officer at Psigma Investment Management, most, if not all, of the returns thought possible from many investments have come already this year.
“The fear of being in cash and missing out on gains is forcing investment decisions that, at any point since the tech bubble, would have looked ludicrous,” he says.
“Using the US S&P 500 as an example, in any ‘normal’ environment, a market trading on 12x earnings and enjoying no profit growth and substantial analyst downgrades would be considered uninspiring. So the US market, which is trading on 17x earnings with no growth expected, looks like a highly questionable prospect.
“In basic terms, all equity markets now need very strong corporate profits growth to justify their premium ratings. While it is certainly possible that we will see healthy earnings growth later this year, it is by no means guaranteed.”
