Trade disputes; rising US interest rates; wage inflation; political uncertainty; presidency ‘by Twitter’; a stronger US dollar; an inverted US yield curve; rising US debt...
…on paper, the case for the US stock market both in itself and relative to other regions would appear weak. Higher volatility only seems to confirm this catalogue of headwinds: the first half of 2018 saw the S&P 500 post 36 days in which it moved by 1% or more compared with just eight in 2017. And yet this year (to 17 August) the S&P 500 was up an impressive 6.6% (in capital appreciation terms, excluding dividends) while other markets have struggled. The Euro Stoxx 50 index down by 3.7%, while the MSCI Emerging Markets (EM) index (in local currency terms) shed almost 6.6% over the same period. The key questions for investors are why is the S&P 500 proving so resilient and how much longer can it last?
From an asset allocation perspective, the US equity market is well supported. The forward earnings yield on the S&P 500 is around 5.7%, which is comfortably ahead of the c. 3.0% offered by the 10-year US Treasury yield. Based on historical data, that additional yield pick-up from stocks suggests a potential annualised return from the S&P 500 of 7-8%1 over the next two years. In other words, the S&P 500 has tended to come through for investors as long as its prospective earnings yield exceeds risk-free yields by a modest margin. That remains the case today.
Focusing on what companies can deliver
Earnings have also assumed a renewed importance precisely because of the uncertain global economic and political backdrop, which is pushing investors into focusing on what companies can deliver rather than what may or may not happen to future economic growth. Here, the US looks stronger than most other regions. Corporate tax cuts came through at the end of last year, while overseas demand for US goods has been robust. Crucially, this is showing in results. As of 27 July, 83% of S&P 500 companies reported a positive earnings surprise, with 77% reporting a positive sales surprise. If earnings season ends with that positive earnings surprise rate intact, it will be the highest ‘beat’ rate for nearly a decade.
The same global uncertainty described above is also causing investors to seek out secular growth over near-term cyclicality. The S&P 500 offers this ‘independent growth’ in abundance, primarily in the form of technology stocks which account for fully a quarter of the index. Compare that with Europe, where the market capitalisation of the entire European technology sector is barely 10% of the US equivalent. This goes a long way to explaining the S&P 500’s outperformance over Europe so far this year. While it is true that EM equities include big tech names, the index is ironically more vulnerable, at the top level, to higher US interest rates, a stronger US dollar and US-instigated trade disputes than the US and its companies themselves are.
This focus on US-listed technology leads to the question of how sustainable the S&P 500’s onward march actually is. Traditionally, narrowing sector leadership within the equity market has been seen as a sign of ‘late cycle’ behaviour or euphoria before an inevitable correction. And over the first seven months of the year (to 31 July 2018), technology has indeed been one of the leading S&P 500 sectors, returning 12.4%. This is just behind the 12.7% return posted by the consumer discretionary sector (which, incidentally, contains the world’s largest online retailer) and way ahead of third-best performer, healthcare, which has returned 7.5%.
Nevertheless, the tech sector’s valuation as a whole is not at a huge premium to the rest of the market versus history. Today, Tech trades at a 10% price / earnings valuation premium to the wider S&P 500. Compare that with the 150%+ premium at the height of the TMT (technology, media and telecom) boom or the 50%+ premium just before the 2008 global financial crisis.
Chart 1: Firmly grounded: S&P 500 tech sector trading at barely a 10% premium
From 1 Jan 1999 to 31 Jul 2018
Past performance is not an indicator of future performance and current or future trends.
In a market environment where investors appear more interested in capitalising on good news than selling on bad news, the S&P 500 appears a global winner as recent weeks have neatly demonstrated. As investors shunned European equities amid the recent political crisis in Italy, it is the US that they overwhelmingly turned to.
While we believe the biggest reward in investing is invariably reserved for the manager who can accurately capture specific stock and sector leaders, the S&P 500 appears to be a compelling catch-all opportunity in itself, as it comes tantalisingly close to its pre-26 January highs. Is this a call for passive investing generally? We firmly do not believe this to be so. The S&P 500 index simply makes a strong case for itself as the liquid, diversified and fundamentally supported core of an actively managed portfolio.
1. There is no guarantee that forecasts will be realized
Originally published in Investment Week August 2018
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.