Forecasters struggle to read U.S. market

It has been a difficult start to the year for the US. Its stock market is down and economic growth has fallen below trend. This has prompted a mixed response from fund managers, who either argue that it presents a buying opportunity for investors or have taken a more defensive position in their portfolios.

In the first quarter of 2005, the US economy expanded at a slower than expected rate of 3.1 per cent although the growth rate would have been an annualised 4.6 per cent without the US trade deficit holding it back. This is its weakest performance in two years.

Lombard Street Research, however, said that without inventory changes contributing 1.2 per cent, growth would have been between 2 and 2.5 per cent. Overall business investment on buildings, equipment and software slowed to a 4.7 per cent growth rate from 14.5 per cent at the end of last year.

Feeble growth

Gabriel Stein of Lombard Street Research says inflation has also accelerated. “The end result is that stagflation beckons, meaning higher interest rates at the shorter end while the prospect of weaker growth flattens the yield curve,” says Mr Stein.

“The GDP growth is the lowest quarterly growth figure since the first quarter 2003. More importantly, it was considerably lower than the consensus forecast of 3.5 per cent, with inflation at 3.3 per cent after 2.3 per cent in the fourth quarter 2004. This dashed consensus hopes of a fall to 2.1 per cent.”

Seeing the signs

The US stock market has also suffered in the first four months of 2005. In dollar terms, the Nasdaq fell 11.4 per cent, the Dow Jones was down 5.9 per cent and the S&P500 declined 5 per cent from the start of 2005 to the end of April. The question for investors is whether this presents a buying opportunity as share prices have become more attractive or whether the slower GDP growth is a sign of a weaker economic environment ahead.

In a sign of caution among some investors, Warren Buffett, the world’s second richest man, has said his company Berkshire Hathaway may return money to shareholders because of the difficulty in finding anything attractive to invest in. At the annual shareholders’ meeting of Berkshire Hathaway on 30 April, Mr Buffett said the company had $45bin (E34.86bn) in cash and, apart from an unnamed insurance firm worth less than $1bn (E770m), had no significant acquisitions in sight.

In early May, the Federal Reserve raised interest rates for the eighth time since June 2004. Rates have now been increased from 1 to 4 per cent over this period. Gregg Powers, manager of the Nordea 1 – North American Value fund, says the stock market’s recent weakness at least partly stems from investor concern that the Federal Reserve’s actions “may prove overzealous, pushing rates too far too fast and thereby risking an economic slowdown”.

But Mr Powers believes investors need to keep these interest rate rises in context. He says: “Less than two years ago, the Federal Reserve responsibly took short-term rates to post-war lows to forestall the threat of worldwide deflation. With the US economy fully recovered and generally healthy, we believe the Federal Reserve is now intent on bringing interest rates back in line with historical norms.

“Given the dollar’s well publicised weakness, the US government’s considerable financing requirements and soft international growth, the Federal Reserve’s challenge to some degree transcends a purely domestic analysis. In particular, certain European economies display signs of weakness. With the US and China positioned as the principal locomotives of worldwide growth, we think it is likely that the Federal Reserve is inclined to err on the side of expansionary monetary policy.”

On the defensive

One fund manager who is cautious about the economic and stock market outlook, however, is Kent Shepherd, manager of the E1.06bn Franklin US equity fund. He has increased his exposure to defensive stocks and says this reflects that he is finding value in stock markets at the moment.

Mr Shepherd stresses that he takes a bottom-up approach to managing his fund. But he is cautious about the macro economic environment. “Earnings grew from 20 per cent to 25 per cent in 2003 to 2004. It was not going to be possible to maintain this rate of growth. Earnings growth has now slowed to between 6 and 7 per cent.

“Company profitability has been boosted by cost cutting over the past couple of years.” He cites the example of the lack of investment by energy companies. “No oil refinery has been constructed in California for over a decade. Corporate balance sheets have been dramatically improved. The US has only undergone a benign recession as consumer spending was so resilient.”

This strong consumer spending enabled corporations to pay down debt and cut costs. Consumer spending was boosted by dramatic house price inflation and interest rates that at 1 per cent reached their lowest level for 40 years.

The recovery in the US stock market from March 2003 was led by small and mid caps, particularly cyclical sectors. This reflected investors heading to higher risk assets, such as emerging market bonds and high yield debt.

Weighty decisions

“The question is whether the out-performance by cyclical stocks will continue, or whether it is time to sell,” says Mr Shepherd. He has been increasing exposure to defensive stocks. “We are overweight Coca-Cola for the first time ever and also now own Anheuser-Busch for the first time. This is because Americans are drinking more alcohol. We are overweight hospital and health services with an 11 per cent exposure against 9 per cent for the index. But we are underweight big pharmaceutical stocks.

“We have an overweight exposure in medical devices and instruments. For example, the fund has invested 1.8 per cent in Boston Scientific. The company had problems when some balloons it manufactures to push out arteries in heart surgery did not work properly. But we have spoken to doctors who like its devices.”

Mr Shepherd also highlights discounters. While consumer spending may slow down, Mr Shepherd argues that people still need to buy food, drink and other basic household goods. If they have less money to spend, says Mr Shepherd, they will go to the cheapest shops.

The value in the stock market is often found in out of favour stocks and sectors. This can, he adds, lead to the Franklin US Equity fund under-performing in the short term. The fund has under-performed the S&P500 over one and three years but has out-performed the index over five years. Indeed, he says he tries to identify stocks that will out-perform over the next three years.

Driven by Google

Mary Chris Gay, manager of the Legg Mason Value fund, however, is bullish about the outlook for the US stock market. The fund has out-performed the S&P500 over each of the past 14 years although it only managed to edge ahead of the index in the last couple of weeks of 2004. She says the strong performance at the end of last year was largely driven by Google and Amazon.

Ms Gay says the fund has a relatively low turnover of stocks compared to its peers. She adds that other US equity funds change more than 100 per cent of their holdings in a single year. “We take a longer term view on stocks of at least three years. This means we usually out-perform over the longer term and have a turnover of around 7 per cent a year.” While in the year to 11 April 2005 the fund returned –0.98 per cent compared to –0.58 per cent by the S&P500, it outperformed over three (–12.82 per cent against –24.09 per cent by the index) and five years (–23.43 per cent compared against –37.17 per cent).

“We think 2005 could be similar to 1995 for the US stock market,” says Ms Gay. “The first quarter corporate earnings season has generally been good with many company results having exceeded expectations. The average earnings grew between 12 and 14 per cent in the first quarter which is above the consensus forecast of around 11.7 per cent. There is strong cash flow and the economy is still growing. Interest rates are rising but are still low on an historical basis.”

Ms Gay attributes the fall in the US stock market to risk aversion among investors. “The US market recovered towards the end of last year when the oil price came down. But the increase in the oil price has detrimentally affected equities again.

Cheap finds

“But we have been finding lots of value in the stock market. The AES Corporation, for example, has grown 109 per cent over the past 12 months but we think it is still under-valued. We are finding cheap stocks in the financial services and telecoms sectors, such as Nextel Communications and Qwest.”

The Goldman Sachs US Core Equity fund takes a quantitative approach and has generated returns marginally in excess of the S&P500 index over one, three and five years.

Melissa Brown, managing director, senior portfolio manager of the quantitative equity group at Goldman Sachs Asset Management (GSAM), says the fund does not take any sector bets. GSAM believes it is possible to beat the index over the long term by selecting the stocks in each sector that offer the greatest value. “As long as we get these decisions right more than 50 per cent of the time then we should out-perform the index.”

Among the factors that GSAM considers when selecting stocks are their valuation, price momentum, whether sell side analysts are upgrading earnings expectations, and estimates of profitability. “Very few stocks meet all the criteria that we use but we overweight those companies that comply with most of them. The average holding period for stocks is six to 12 months,” says Ms Brown.