March 2017 marks the eighth year since equities bottomed following the global financial crisis. US equities, in particular, have benefited from the subsequent rally, with the S&P 500 index climbing roughly 250 per cent and the Russell 2000 index roughly 300 per cent.
Many investors have wondered if US equities are poised to decline, since margins are near all-time highs and multiples on earnings (which reflect those peak margins) are well above historical levels.
We recognise these risk factors but believe that they are excellent reasons why active investment strategies can be a better option than passive, particularly at this point in the market cycle. While we cannot forecast the market level with high confidence in 12 or 24 months, we can continue identifying companies that in our view exhibit high sustainable profitability and attractive valuations.
Much of the recent rally has been driven by valuations, as earnings per share (EPS) growth has been relatively modest.
Since the US election, the S&P 500 index has risen roughly 10 per cent, the Russell 2000 index has risen roughly 14 per cent, and volatility has remained low, despite heightened political uncertainty.
Performance of indices over 6mths
Source: FE Analytics
The rally in equities also reflects the expectation for significant earnings growth in 2017 and 2018. In 2015 and 2016, S&P 500 Index earnings declined by 1.4 per cent and 0.7 per cent, respectively, as energy and materials companies in particular endured sharp declines in income.
Looking forward, S&P 500 index earnings are expected to increase by 11 per cent in 2017 and 12 per cent in 2018 on the back of the energy earnings recovery and stronger earnings across the rest of the market.
Furthermore, it is important to place valuations in context. While the forward P/E ratio for the S&P 500 index was 18.2 times as of 24 March, or 2.9 times above its 10-year median, a number of factors suggest that equity markets should be valued more highly than they were in the past.
Equities generally appear more attractive than debt
During this period and the two decades that preceded it, interest rates have progressively fallen in the United States and across the developed world. Even with the recent recovery in yields, we expect that they will remain low relative to their pre-crisis level, making equities more attractive on a relative basis.
Performance of Bloomberg Barclays US Corporate Investment Grade vs MSCI North America over 1yr
Source: FE Analytics
Profit margins have expanded structurally
For several years, investors have worried that US profit margins have been at or near record highs and could be susceptible to downside. We would argue that there are several factors contributing to the increase in margins.
For several years, investors have worried that US profit margins have been at or near record highs and could be susceptible to downside. We would argue that there are several factors contributing to the increase in margins.
First, there appears to be a structural uptrend in margins for the S&P 500 index. We believe this reflects changes in the composition of the market, as investor interest in “old economy” companies that typically had lower margins and higher capital intensity has faded and has been redirected to “new economy” stocks that often have lower capital intensity and higher margins.
A good example of this would be the shift in market weight toward technology and, within technology, the shift in weight toward software and services and away from hardware.
Another factor could be the sharp fall in the number of listed stocks in the United States since 1996, in part due to robust merger and acquisition activity. As Credit Suisse has noted: “As a consequence of this trend, industries are more concentrated and the average company that has a listed stock is bigger, older, more profitable, and has a higher propensity to disburse cash to shareholders.”
Finally, Morgan Stanley data shows that mega cap companies, defined as the top 50 stocks by market capitalisation, have driven margin expansion since 1996, while margins for smaller companies have remained relatively stable.
This implies that the largest companies in the United States as measured by market capitalisation have succeeded in some combination of a) optimising their global operations, b) financially engineering their way to higher returns, and/or c) acquiring other companies that could pose a threat to their market position.
This also could reflect the shift we described above, which is that two of the largest companies in the world, Apple and Google, are technology companies with high margins that have superseded companies such as ExxonMobil and Wal-Mart, which remain in the top 50 but have much lower profit margins.
Stronger balance sheets
Corporate balance sheets are in much better condition than they were through much of the past 20 years. Firms have taken advantage of record-low interest rates to term out their debt and lower debt servicing costs, reducing the risks that might arise in a future recession.
Alongside these factors, there are a number of other bear and bull case arguments that could be made about potential remaining market upside.
There are two sides to most of these arguments, but they generally revolve around the underlying strength of the US and world economies, geopolitical risk factors, upside and downside scenarios around legislation, sentiment and the risk of reversal, as well as monetary policy changes and interest rates.
When we take all of these points and counterpoints into consideration, we remain confident that the US equity market continues to have upside.
While it is easy to get caught up in the short-term ups and downs of market psychology, we remain focused on the fundamentals of the global economy and the companies in which we invest.
We see a picture that is improving on the back of the broadening recovery in middle class finances and what appears to be a synchronised global recovery.
We see a wider range of potential outcomes for the economy and markets as a result of the recent US elections, but we also believe that investors have focused too much on legislation and not enough on the resilience of this recovery and the strong underpinnings of growth.
We recognise that some stocks have likely run ahead of their fair value based on unrealistic expectations—in many cases for policy change where the legislation has not even been drafted.
However, we also see many other stocks that have drawn comparatively little investor attention and yet have offered strong returns on capital, solid balance sheets, and attractive valuations. Moreover, the substantial decline in pairwise equity correlations since the US elections likely has opened the door to better security selection opportunities for active managers.
Martin Flood is a portfolio manager at Lazard Asset Management. The views expressed above are his own and should not be taken as investment advice.