Can the bull run continue?

US markets have touched eight-month highs on a wave of economic optimism, boosted by strong home sales which have risen for the third consecutive month, and forecast-busting results from a number of US household names such as Intel, Goldman Sachs, 3M and AT&T. July was particularly strong with the Dow Jones Industrial Average climbing almost 1000 points in two weeks. By late July, the index closed above the 9000-point mark for the first time since January. But while that marked a turning point in confidence, the bull run is unlikely to be maintained. Cutting costs The reality is that earnings surprises are coming from cost cutting rather than revenue growth. While chip maker Intel Corp and Wall Street powerhouse Goldman Sachs bucked the trend, most earnings announcements were a déjà vu of the first quarter, when tough cost-cutting boosted bottom lines while sales growth remained elusive. By mid-July, 75 S&P 500 companies had reported earnings and they exceeded their earnings estimates by an average of 16.1 per cent, but revenue has beaten forecasts by just 4.4 per cent, according to Brown Brothers Harriman, showing that the improvement is largely a result of cost-cutting. With an unemployment rate of almost 10 per cent and one that is likely to remain high into 2011, sales growth on the back of consumer spending looks unlikely. Moreover, job insecurity is combined with declines in home values and tight credit, and the deleveraging process of the over-indebted US consumer is far from complete. “Earnings surprises have been a feature of the US market for the last three quarters, but US companies cannot cut costs much more,” warns Seung Minn, lead portfolio manager of the Allianz RCM US Equity fund. “It’s a complex market situation. US companies have shown amazing flexibility and resilience in dealing with fading demand for products by cutting costs, but companies will now have to gain revenues from the top line,” he explains. “What worries me is the comparison between current profit margins and the previous worst periods. For example, in 1991 and 2001 profit margins dropped to 4 per cent, but as a country we’re still making 6 per cent, excluding financial and utilities, so there might be even poorer profit margins coming up. If I see a decline to a 4 per cent level or lower, then I might feel that the market has finally bottomed,” adds Mr Minn. Various surveys have suggested that more than half of US corporate chiefs still plan to cut costs for the next six months, and nearly half anticipate a further decline in sales. Nevertheless, there is a groundswell of opinion that the business world has proved more robust than expected, and might even be on the road to recovery. Missouri-based Daniel Becker, vice president of Waddell & Reed, who co-runs the Pictet US equity fund, points out for example that cash earnings have not fallen as sharply as the stock market. “The market is down 60 per cent peak to trough, but free cash is generally not down nearly as much, so corporations are doing much better than the market,” says Mr Becker. “This makes the snapback somewhat rational, because the market correctly figured out free cashflow is good and the margin structure of these companies is exceptional.” Return on equity (across the market, ex financials) is 15 per cent, adds Mr Becker. “We’re in the worst recession since the Great Depression but we can still generate 15 per cent with a shrinking sales base – that might be entirely cost base savings but it shows how strongly and aggressively managements have attacked cost structures,” he explains. “Although valuations are higher than six months ago, the market is still cheap,” he adds. “Historically the free cash flow yield (per share) has averaged 4.5-4.6 per cent but it peaked at 9 per cent, and is now on around 7, so gains may be possible just to get back to the long-term average.” Investors circling Investors have been moving back into the sector in anticipation of an inflection. “We’ve seen a recovery in sentiment that had been so negative and in prices that had been so beaten down,” says John Carey, fund manager at Pioneer Investments. “A surge of people have moved out of fixed interest to reposition themselves in the market. While GDP and corporate earnings have bottomed out, it may be six to nine months before the economy recovers but it is best to get positioned now,” he says. “We’ve studied market results over long periods, and much if not most of the gains come before the turn in earnings, so if you sit on the sidelines and wait, you will miss out on the rally,” Mr Carey adds. “At the beginning of the year, we indicated that the US market has the opportunity to earn a double digit gain for investors this year and we are sticking with that,” says Bob Doll, global chief investment officer of equities at BlackRock. “As an initial estimate, we would suggest that the S&P 500 could reach 1000 to 1050 by the end of the year,” he explains. “While at the beginning of 2009, that estimate might have appeared to be a little optimistic, now it may seem a little pessimistic given the large run markets have experienced since the market lows in March. However, we continue to stick by that view and would look to add on weakness,” says Mr Doll. Aggressive initiatives “Among the developed markets, we prefer the US due to the more aggressive fiscal and monetary policy initiatives compared to the rest of the developed world,” adds Mr Doll. “However, we continue to say that investors should not overlook the developing markets. The recessions experienced within the developing markets are more typical in nature led by inventories and not credit driven recessions,” he explains. “The developing markets should recover much more quickly than the rest of the world and the impressive fundamentals we were all discussing 18 months ago are still in place.” Technology has been the best performing sector with the tech-biased Nasdaq registering its longest winning streak since 1992 with a 12-day rally in July, eventually halted only by disappointing results from index heavyweights Microsoft and Amazon. The sector boasts fantastic balance sheets and cashflows, and is benefitting from a falling dollar and from emerging market demand. IT spending is turning out to be less discretionary than anticipated, and the industry is not on President Obama’s regulatory radar. “The recovery from the March lows was mainly driven by financials and cyclicals, that is, stocks of companies that benefit from an improvement in the economic outlook,” says Christian Gattiker, head of research at Bank Julius Baer, Zurich. “We think this trend is going to continue after the seasonally weak period in the third quarter. Therefore we expect another buying opportunity, in particular in cyclical sectors such as IT, industrials, materials and energy come September/October,” he explains. Mr Gattiker also highlights the impact of the American recovery and reinvestment act (ARRA) of 2009, which should benefit broadband technology, clean energy and healthcare IT. PWM’s table of funds is an eclectic mix of large indexed funds and some very mature stock picking funds, such as the Pioneer fund, the third oldest mutual fund in the US, which has been run by Mr Carey since 1979, while Mr Minn has run the Allianz RCM US Equity fund since 1998. “The market dislocation and volatility of the last year has resulted in a rich set of opportunities for stock selection, with valuation spreads at an elevated level historically across the majority of sectors,” says Ian McIntosh, director, global asset management at UBS. “In particular, from the perspective of our long-term fundamental research, there are highly attractive relative valuations within the industrials and consumer discretionary sectors. It is an excellent time for active stock picking based on a long-term time horizon,” he adds.