Alpha from uncertainty
The market crash and subsequent super rally has investors in disagreement over the prospects for US equities. This suggests that active management will now make a difference, writes Joseph Mariathasan
According to Bill Miller, CIO of Legg Mason Capital Management, bull markets typically begin when four conditions are present - the economy and profits are bottoming, the Fed is stimulating, and valuations are low. “That’s where we are now,” he declared in mid-July. By mid-August, the S&P500 had rebounded 50% from its March low - one of its strongest rallies ever. Yet as John Carey, US fund manager at Pioneer argues: “The US is in for a slow recovery and the markets may have jumped the gun.”
Did those who did not have a large exposure lose out, or is this the beginning of a much longer-term trend? If the good times are set to continue, how should one be positioned?
Colin Robertson, global head of asset allocation at Hewitt Associates, sees this as a liquidity-driven rally. As he argues, in March the financial markets were still pricing in Armageddon: “A lot of what has happened is justified, but is all of it? We know there is lots of money going to banks and they are not lending it out, so some is leaking into the equity markets.” This is a view echoed by Simon Moss, investment director for US equities at Scottish Widows Investment Partnership, who sees the rally as a function of the quantitative easing programme undertaken by the Fed combined with unattractive money market yields. “It has been the deep value, small-cap names that have rallied the most over the last few months and they are more involved in economically sensitive areas,” he adds, voicing concern that the rally might falter over the next few months. “Past rallies like this have been in a bear market.”
For John Eisinger, US All-Caps manager at Janus Capital Management, the rally was driven by better-than-expected cashflows and earnings, underpinned by aggressive cost cutting, but to continue it will require improved revenue growth as well. “The incremental margins on increased revenues will be very high, given the cost cutting that has been occurring,” he says. The scope for revenues to grow in the new environment is debatable, leaving investors to decide whether to maintain beta exposure or look to defensive names that can ride out a lacklustre market.
Taking the longer view, Mary Chris Gay, a value manager at Legg Mason, is optimistic. She points out that the S&P500 was down 5.9% over the 10 years to 9 March and that the only other negative 10-year period was during the Great Depression. Annualised since 1926, it has returned 10%.
Investing at exactly the low point of any 10-year period would have bagged you 13% on average. A year too early and your return would have been 12.3%; and a year too late, 10%. Moreover, in mid-August the index was still down over a 12-month period and, in terms of valuations, Gay says that we should think about what the appropriate price/earnings multiple might be for a low-inflation environment. P/E ratios were around 14 in mid-August and had been as low as 11. But in previous periods when inflation was less than 1%, such as the 1960s, the index P/E ratio was over 18.
But even if investors agree that we are seeing the start of a multi-year bull run, they should probably also accept that the easy money has already been made. “Going forward, what matters is the relative rates of corporate and economic restructuring between the US and Europe,” says Shahreza Yusof, head of US equities for Aberdeen Asset Management. He feels that the US authorities have put themselves in a decent position. “What Japan took 12 years to do in terms of aggressive stimulus policies took US authorities six months,” he says. The same goes for the corporate sector: Japanese firms at the beginning of their crisis were highly leveraged and speculating wildly in equity markets and property.
By contrast, US companies had recently come out of the tech bubble chastened and leverage has largely been confined to consumers. Still, while production can restart, it will be at a much lower level. With the US economy driven by consumer spending, Yusof notes that stable employment is essential: “Unemployment is still growing. Not that long ago, Germany had unemployment in the teens, whilst in the US it is currently around 10%. Will it go down, or will it go up?”
Indeed, at Wood Asset Management, based in Sarasota, Florida, which aims to generate 50% of its excess returns from macro calls, CIO Harald Hvideberg expects a global recovery extending well into 2010 at least, and positions his portfolio to take advantage of pro-cyclical sectors such as industrials and technology, as well as financials, that derive a major portion of earnings from outside the US. “There is evidence that many emerging economies are already coming out of the recession, as well as the euro-zone,” he says. “The US is likely to be out of a recession by Q3.” Hewitt’s Robertson argues that US large caps are well placed to benefit from Asia’s growth, adding: “You don’t want to be exposed to US consumer final demand.”
But do US domestic fundamentals really look so bad? Eisinger points out that the annual rate of household formation in the US has been at 1.0-1.5m for decades, as opposed to recent figures of 400,000-500,000: “We know that as excess inventory is sold, this figure will move from 400,000 to 1.5m.” Gay notes that the “cash-for-clunkers” programme to encourage new car purchases was sold out within th ee days as “people are prepared to spend given the right incentives”, but also counters that markets don’t always need a consumer-led recovery. “At the beginning of a long-term bull market, the economy is bottoming, profits are bottoming,” she says. “The Fed is still in a very stimulative mode. Tim Geithner and Ben Bernanke have said they would not reverse the stimulus prematurely and risk tipping the economy into a recession, so interest rates are still essentially at zero.”
There are risks on both sides of this equation, of course. Equities do best in a period of moderate inflation, but the current fear is that there will be short-term deflation followed by medium-term high inflation. Deflationary fears are driven by the large output gap that followed the violent negative shock to demand as consumers retrenched. With US unemployment at over 9% and increasing, past relationships between the output gap and inflation imply that the US will still be in a deflationary environment next year. Yet, extracting the economy from the potentially inflationary effects of the enormous increase in the money supply is heavily reliant on the Fed making no mistakes in its ‘exit strategy’.
Robertson also sees the risk of a W-shaped recession: “Inventory de-stocking accounted for -0.8% of GDP growth last quarter, so if inventories don’t change, this will add 0.8% from just an absence of de-stocking.” However, US consumer final demand is still weak, so any inventory-led recovery could stall easily - and this is all without taking account of other headwinds listed by Eisinger, including ageing demographics, high deficits, no clear strategy to reduce government spending, and the prospect of higher taxes.
So fund managers have highly divergent views on the beta story but, predictably enough, there is consensus that market volatility gives stockpickers a bountiful new environment in which to prove their skills. “I don’t think the S&P500 will generate any return at all over the next five years,” declares Simon Laing, head of US equities at Newton Investment Management. “But if we don’t show our abilities over the next five or six years, woe betide us as active managers.”
Some firms are seeking to take advantage of an environment that might be more conducive to stock picking. T Rowe Price has a successful research-led portfolio that sticks closely to the S&P500, with over 100 names selected by its in-house analysts, but it has recently launched a concentrated large-cap portfolio strategy based on investing in 60 or so of the highest-conviction ideas. “Our clients were looking for a large-cap strategy with much higher tracking errors and flexibility than seen in traditional products such as large-cap growth and large-cap value,” says portfolio manager Jeff Rottinghaus.
So what do managers like at the moment? It is not difficult to find managers, like Hvideberg or Gay, who are now looking at financials: they remain under-owned, inexpensive and operating in a new world of massively reduced capacity.
In contrast, Newton Investment Management adopts a theme-driven approach with its deleveraging theme steering it away from financials. For the US, the powerful drivers are what it calls the ‘networked world’, ‘medical technology’ and ‘low-end spend’. US companies are at the forefront of the internet and mobile telephony revolutions and, as Laing points out, the sector’s post-TMT bubble problems have led it to construct conservative, cashed-up balance sheets. Laing sees medical technology benefiting from the Obama stimulus to healthcare, as well as the ageing of the baby-boomers, and he would also like energy for long-term growth if prices were to pull back somewhat. The “low-end spend” theme reflects the impact of the financial crash: with long-term debt reduction and consumers increasingly living within their means, Laing expects higher-end retailers to suffer relative to the Wal-Marts of the market. This last theme is one that Gay also agrees with for the moment.
Views on relative valuations between small and large caps are mixed. Colin Robertson at Hewitt Associates believes that small caps look expensive: while they usually underperform in recessions, they have so far outperformed large caps in this one. Small caps do outperform as credit spreads contract - but there is plenty of evidence that we have seen that particular rally played out already, while large caps will tend to benefit in higher-volatility regimes - which most people are expecting for the foreseeable future.
He also compares IBES consensus forecasts for 2011 with realised earnings in 2007, before the crash: “While large-cap estimates are 5% more in 2011 than 2007, small-cap ones are 150% higher,” he says. “Somebody has lost the plot.”
Nonetheless, Eisinger, who runs a concentrated 30-50 stock portfolio for Janus Capital with a Russell3000 primary benchmark unconstrained by size, finds many small caps substantially cheaper than large caps. He also notes that several large caps have indeed outperformed small caps over the past year. “Their greater volatility requires a more stable economic environment for them to outperform large caps over time,” he says. “A lot of the outperformance of large caps in the past year happened because they did not go down as much as small caps.”