Current US valuations, impending rate hikes from the Federal Reserve and a stronger dollar shouldn’t mean that the US stock market rally will come to an end, according to JP Morgan’s Fiona Harris and Old Mutual’s Ian Heslop.
Both fund managers believe investors should think twice before rotating out of US equities following a six-year bull market that has pushed up valuations and left many feeling that the end of continued gains might be in sight.
Performance of indices since 2009
Source: FE Analytics
In an article last week, a panel of experts told FE Trustnet they shared the consensus view that it was time to reduce exposure to the US or even sell out altogether. 
Premier’s Simon Evan-Cook, Psigma’s Tom Becket, Bestinvest’s Jason Holland and L&G’s Justin Onuekwusi are all bearish on the US at the moment and have instead opted for Japanese and European equities for their cheaper valuations and greater growth prospects.
“Valuations are looking less attractive for US equities so we’re looking to phase in a decrease to US equities over time and increase our weightings in Europe and Japan,” Onuekwusi explained. “Although the US is a big gross consumer, the oil industry in the US does contribute to US growth, therefore the fall in oil price impacts US growth as a negative as well as a positive. When you look at this, the biggest beneficiaries of the fall in oil price are Japan and Europe.”
The fund manager also listed Japan and Europe’s use of quantitative easing and the weak euro as reasons why these developed markets are more favourable than the US.
However, Harris (pictured) says investors should question whether US equities really are too expensive and whether they have reached the top of their potential.
“The US equities bull market may be getting long in the tooth, but investors should reconsider before they rotate out of their US equities exposure. There are solid reasons to believe that the US party can continue for some time,” she said.
“We don’t claim that this market looks inexpensive following several years of spectacular gains, but there are some significant reasons why valuations alone are not valid signs that investors should be taking profits or expecting a correction.”
“For example, many investors cite the current price to earnings [P/E] ratio on US equities looking stretched as a reason to bail out of the asset class. But let’s look a little closer. Even after returns of more than 200 per cent since the financial crisis, we’re currently on 17x P/E, which is about fair value. It doesn’t feel cheap, but the market isn’t demanding.”
JP Morgan research suggests that annualised returns over the three years after US equities reach a 17x P/E tend to be 16.9 per cent, while over five years it’s 9 per cent annualised.
“It is not until the market gets to more than 20x that future returns begin to look challenged,” Harris pointed out.
P/E ratios vs total returns over next 12 months
Source: JP Morgan Asset Management
Following the start of the bull market in 2009, even US equity bulls have had to contend with valuations at elevated levels.
While US energy, industrials and utilities sectors have dropped since the start of the year, healthcare has already rocketed by 10.12 per cent and consumer discretionary has climbed a substantial 6.42 per cent.
Performance of sectors in 2015
Source: FE Analytics
Although equity prices are currently being supported by low interest rates, this will no longer be the case when the Fed hikes rates at some point in the near future.
“It’s all eyes on the Fed until we see the first lift-off in rates in September or potentially December of this year,” Harris said.
“We know that we’ve gotten beyond the patch of weak economic data earlier this year and are returning to stronger growth, as signalled by the healthy labour market data in recent months. Ironically the marginal uptick in the US unemployment rates is actually a positive indicator, in that it suggests more workers are motivated to rejoin the job search as the economy gets brighter.”
“The big question is whether the Fed will feel comfortable enough with the resilience of the underlying US economy to begin the path towards normalisation.”
The US equities specialist adds that the rate rise is unlikely to have a negative impact on US dividend-paying stocks as, according to JP Morgan’s research, there is in fact a positive correlation between rising interest rates and rising equity prices when interest rates are rebounding after a low point.
“When interest rates are rising from a low base, there is a positive relationship between yield movements and equity returns on both the S&P 500 index and the MSCI Europe index,” Harris explained.
“The markets’ initial reaction to an interest hike tends to be a pullback reflex, but markets then tend to revert back to a strong upward trajectory following a rate rise. Therefore, we argue that an interest rate hike in the context of a more healthy US economy is unlikely to derail shares.”
Ian Heslop, head of global equities and manager of Old Mutual North American Equity, also points out that the health of the US economy means that people shouldn’t be selling out yet, saying that there is still room for growth in the notoriously efficient market.
“While exporters were hit in the first-quarter results season (and yes 45 per cent of S&P companies are overseas earners) domestic companies fared relatively well. Regarding softening GDP numbers, we bulls prefer not to talk about output but national aggregate income which, for the first quarter, registered 1.4 per cent annualised growth. Economists still think there’s no reason for the US not to register 2.5-3 per cent growth in the second quarter annualised,” he said.
“For me it seems as though we are still in the sweet spot of equity investing. The risk of the US Federal Reserve tightening has been kicked a little bit further into the long grass and, if the IMF [International Monetary Fund] has its way, is likely to stay there for some time to come. Yet raising rates is a sign that the economy is not only off life-support but recovering well in the process.”
Heslop adds that corporate confidence in the US is shown through the escalating values of M&A deals in the region.
Research from Dealogic shows US acquisitions into Europe, the Middle East and Africa reached $116bn via 410 deals by the beginning of February this year. This is almost triple the $38.9bn announced year-to-date at that time in 2014.
In May this year alone, US acquisitions totalled $243bn and Heslop believes that if this rate continues, the figure could easily beat 2007’s record by the end of the year.
“If management didn’t believe the economy was stable they wouldn’t be committing such large amounts of cash to buying other businesses, surely?” he questioned.
“And corporates are right to be optimistic. The US economy is one of just three to experience self-sustaining growth in 2014 – the other two being India and the UK. Corporate margins are nearing 50 year highs and, unlike many, I see no reason for them to revert to the mean given the double tailwinds of a fall in oil prices and advances in technology.”
However, Heslop notes that the rate of corporate investment still needs to increase, as he believes that US companies are more concerned with returning cash to shareholders than growing their businesses.
While he notes that risk appetite in the US market has increased since lows in October 2014 and that growth stocks are favoured over value at the moment, he warns that the rotation from growth to value and back to growth could change at any point.
“The recent correction in global bond markets suggests that point may not be too far away,” he suggested.
“While style volatility has been less pronounced in the US than Europe that’s not to say it doesn’t exist. Watch this space. The trick is, as ever, to keep alpha returns diversified.”