Anyone welcoming the unrelenting gains posted by the US stock market this year is no doubt also slightly perturbed by its increasingly elevated valuations. The S&P 500 has surged by 28% since January, exceeding the MSCI World’s climb of 27% and the FTSE All Share’s 17%.
That rise has left the S&P 500 trading on a Shiller cyclically adjusted price-to-earnings ratio of 25.08. Its average multiple over the past decade has been 23.04. The current reading is the highest since December 2007. What came after that date will be scorched into every investor’s memory.
‘We feel the premium is justified and sustainable. We like the US domestic earners. If rates are rising in the US it means the consumer is confident and there is a strong US recovery. We like regional banks that can benefit from greater interest rate margins,’ he explained.
With this in mind, Coombs expects to overweight the US over the next three years. ‘I see the US as a long-term overweight. We have been increasing our overweight over the last 12 months,’ he added.
He highlights the £330 million Brown Advisory US Equity Value fund, run by Rick Bernstein, as one of his favoured funds. Over the past year it has returned 30.8%, beating both the S&P 500’s 27.2% and the 28.3% from the Russell 1000 Value index through the same period.
Coombs’s enthusiasm for the US is shared by Nancy Lazar, head economist at Cornerstone Macro, and who has long declared what she calls ‘Middle America’ her ‘favourite emerging market’ thanks to its renaissance as a shale and now manufacturing hub. She recognises that the country does face serious challenges, such as high government debts and a low saving rate. ‘However, there are more tailwinds, which will make it easier to grow and in turn delever.’
Lazar notes that even the recent strong run in the US may not reflect its true strength. ‘Fiscal tightening at the federal level amounts to about $311 billion (£190 billion) in 2013, or 1.9% of GDP. Next year it is likely to be just 0.3% of GDP, so significantly less fiscal drag will help boost real GDP by at least one percentage point. So if real GDP growth is 2% this year, growth could be over 3% in 2014.’
To assess how this benefits companies, Lazar draws on data from the Bureau of Economic Analysis rather than the S&P, as the former captures all business activity rather than just that of the mega-caps. She has found that this reveals third-quarter corporate profits raced ahead by 17% quarter on quarter and 8% year on year. ‘Record high profits are a core support for business spending, i.e. both employment and capex.’
Of course, it is record highs that make many anxious: the risk is that they will revert back down to their long-term averages. ‘I adamantly disagree,’ argues Joanna Shatney, head of US large-cap equities at Schroders. On an aggregate basis she points out that the S&P 500’s operating margin is 15.6%, still below its historic peak of 19.5% in 2007.
The scope for improving margins further is even more pronounced in certain sectors. Industrials have operating margins at the moment of 14.3% compared with 16.7% in 2007, while in financials the present number is 24.9% against a high of 40.2% six years ago.
Shatney’s base case for 2014 has earnings per share growing by 8%, and she concludes that the S&P 500 therefore still offers 9% of upside. Even in her bear case earnings per share will increase by 5%, suggesting a potential upside of 6% next year.
For Shatney, then, the US is ‘a utopia for equity investors’.