We see five key reasons to be positive about the outlook for the US stockmarket.
The US has had four years of surging stockmarket returns, and we sense that global investors are worried about further upside from here. While we have some near-term concerns about the 2014 budget planning process playing out over the next few months, we believe this near-term hiccup will be a buyable dip. The last two years have been characterised by exceptionally aggressive monetary policy easing due to tepid economic growth. We believe that as the Federal Reserve (Fed) begins to unwind its accommodative stance, it will only be in conjunction with accelerating economic growth rates, which should continue to provide support for a positive environment for US equities. We also see cyclical tailwinds from housing market improvements and an eventual up-turn in capital spending. Secular growth drivers including innovation and a strong US competitive advantage will also continue to be supportive drivers.
1) The S&P500 is at highs but is also supported by record profit levels– fundamentals support more upside
Does four years of upturn in US stocks mean no more market opportunity? No. The upturn in the US is based on a real fundamental recovery. We see 5-10% earnings per share growth annually as the underlying support for our optimistic long-term view. Investors have forgotten that while the US market is at all time highs, so are corporate profits, which is unlike other global equity markets where growth has slipped significantly. Corporate profits are now 20% ahead of their previous peak compared to the market being 10% above its all time high. While many will say quantitative easing has helped support a market recovery, we simply think too many are forgetting that fundamentals have been the most significant driver of the market recovery. Investors should also keep in mind that while price-to-earnings (P/E) multiples are up from their lows, they are not stretched relative to history or compared to other risk assets.
2) Don’t fear the Fed
We have been the small minority at Schroders expecting the Fed to be reluctant to taper with GDP at a modest 2% run rate. The Fed has a dual mandate that focuses on growth and has stated that it does not plan to raise interest rates until unemployment reaches 6.5% (currently at 7.4%). With tepid GDP growth, and unemployment above target and inflation below target, we do not expect the Fed to make draconian changes in its policy over the next 18 months. We are disappointed that we have not seen GDP accelerate back towards 3% growth or better, and continue to believe the Fed will remain accommodative until we get there. We view this balance of economic growth and balanced Fed policy as a utopia for equity investors.
3) For investors seeking real returns, greater conviction in economic growth will force investors into equities
For the past few quarters we were focused on the relative P/E ‘cheapness’ of equities versus bonds. We have now shifted our focus to another interesting valuation point – the free-cash-flow yield for the stockmarket – which is still at very high levels despite the significant market appreciation over the last three years. US companies boast strong absolute levels of cash generation relative to history, positive cash outlooks against already record high levels of cash, and strong balance sheets. This provides management teams with significant levers to pull to add to shareholder return over the next three-to-five years.
Historically, cash redeployment has come at the peak of market cycles. However, pushing management teams to be active in the early part of the economic up-cycle should be an incremental differentiator to the US market versus previous cycles. We continue to believe that pressure will increase on management teams to begin to deploy cash, and activism is increasing – even in large capitalisation stocks.
4) Cyclical drivers for the US Market: housing and capital spending
The US housing market is still a tailwind for the economy
The US housing sector has now entered the second stage of the cycle where fundamentals drive accelerated earnings growth. While the rebound for housing stocks has been strong, up around 200% since 2012, the group should continue to outperform the market, even if multiples start to compress.
A crucial component of the housing recovery is inventory, including foreclosed/shadowed homes, which has fallen well-below normalised levels over the last three years. As a result of a clean inventory position, housing starts – the number of new residential construction projects that have begun during any particular month – are forecasted to reach 1.2 million for 2014. This sets the sector up for another few years of 30% growth rates and still sets a level that is below prior industry peaks. Additionally, in almost all previous housing cycles, growth exceeded the long-term average by more than 25% – if this were to occur, healthy estimate revisions could exist beyond 2015.
Home prices, another important component in the housing recovery, rebounded strongly in 2013; up almost 12% from the bottom although significantly below peak from five years ago. Higher home prices help consumers fund renovation and remodeling. Our favourite housing related names have leverage to both the up-turn in new construction (housing starts) and renovation.
Mortgage rates are an important driver to the stocks and housing fundamentals (a function of Fed rate stance). However, the key to outperformance is where we are regarding housing starts, ultimately tend to be a better indicator of housing prices. Therefore, we believe we are in a correction phase (housing stocks are down about 20% over the last three months), which has happened during every single housing cycle since 1982 (Chart 1).Given the sharpness of the correction and our expectations of a modest growth environment for the US economy, we should still see further outperformance.
5) Secular growth themes are being underestimated by analysts
1. Innovation – Companies with an innovative tilt are significantly better positioned to outperform peers and the overall market and the US continues to dominate the global market cap of healthcare and technology. This is because of the simplicity of forming businesses, intellectual property protection, and the availability of credit. Historically, we have used Apple as the most extreme example of innovation but today, there a number of companies where innovation is core to our investment thesis.
2. Competitive advantage – 1) Energy cost advantage – the natural-gas surplus has helped pricing plummet for ethane – the main input of US chemical manufacturers . A similar cost advantage story exists in paper manufacturing and 2) Manufacturing flexibility has allowed US companies to begin to compete globally even with a rising dollar, for example, the US Auto industry has reconstructed itself post-bankruptcy
3. Demographics – Of the developed markets, the US is best positioned to deal with some of the secular challenges it faces with the ageing baby boomers. Immigration, for example, has helped offset a lower birth rate allowing for overall population growth through a business cycle. Over the long-term this provides ample growth in areas like housing. From a company specific point of view the aging population also supports stock ideas in healthcare.