The US dilemma just got harder

Advocates of US equities point out that the US is still full of good companies and that the market has proved resilient, due to the sheer weight of money pouring into it.

Tim Gregory is head of global equities at PSigma and believes that US equities are trading modestly above fair value, "but not ridiculously so". "Interest rates and bond yields are going to stay low and this allows equities to trade at slightly higher ratings for a while yet," he says.

"The US has a lot of very high quality businesses and they have PE [price-earnings] multiples that reflect their strength. We have a pretty neutral view of equity prices in general. Our view of fair value for the S&P 500 is 1950. US equities should be able to make modest progress up to the end of 2015, but not enormous progress."

But Ben Seager-Scott, director of investment strategy at TilneyBestinvest, is more circumspect, saying he was surprised that valuations did not stabilise at a more realistic level following the volatility in mid-October.

"While it is true that earnings growth continues to be strong in the US, which could be a reason to pay a bit of a premium, our concern is that much of this seems to be coming through in cost-cutting and increased operational efficiency, rather than an improving top line."

He says the lower production and transport costs enjoyed by many US companies have been helped by falling commodity prices and access to very low energy costs from shale gas. The flipside, he says, is that eventually interest rates and wages will rise, both of which, he believes, will put pressure on profit margins.

Others point out that GDP growth in America has been a bit disappointing.

Darius McDermott, director at Chelsea Financial Services, says: "At the start of the year people thought the US was going to grow at 4 per cent, whereas it has been nearer to 2-2.5 per cent. So on most historic measures, US equities would be deemed to be expensive, but not very expensive."

However, Mr Gregory says it is difficult to ascertain precisely the underlying growth rate of the US economy, due to Q1 and Q2 of 2014 having been skewed by bad weather and Q3 including an element of catch-up. But generally he sees the US economy's momentum and trajectory as "considerably better than many other areas".

Mr Seager-Scott is concerned that despite the near-$4 trillion of liquidity pumped into the system through QE programmes, little of this has flowed through to the real economy as hoped.

“Overall, we see valuations in the US higher than we are totally comfortable with," he says. "Markets are at risk of being priced to perfection, meaning any disappointment or negative surprise could unsettle complacent markets. The withdrawal of QE-related liquidity could herald the end of the good times in equity markets.

“Of course, we’ve seen markets trade irrationally before, so timing is always a tricky thing. On that basis, whilst we would be relatively cautious on the US. That is not to say we would avoid it entirely, rather we’d be looking to take an underweight position.”

Other risks

Although the key risk of staying in the US market is the valuation, other risks include the potential for a global economic slowdown, a substantial downturn in US PMI indices, a geopolitical crisis and an ebola epidemic in the developed world.

Mr McDermott says: "The risk of ebola spreading to the US is a real concern. Look at what happened when SARs hit the Asian markets 10 years ago. Asian stock markets reacted very badly."

Profit warnings could also trigger a correction, but the big September market sell-off was more to do with geopolitical factors and concern over a global slowdown in growth.

The US is heavily affected by events elsewhere, for example the slowdown in China and Europe and the drop in oil and other commodity prices. Mr Gregory says: "A large portion of the US economy needs the world to be doing well."

So what does the future hold for the US market? A Republican-led Congress is expected to press for pro-business reforms, such as the liberalisation of energy exports, a loosening of constraints on banks and a repeal of the tax on medical devices that funded Obamacare. But on international trade talks with Asia and Europe, president Obama is expected to receive support from the Republican-dominated Congress.

Tom Stevenson, investment director at Fidelity Personal Investing, points out that US mid-term elections have typically heralded a rally in the Dow Jones index after a decline leading up to the vote.

So the US market may have further to go, or political stalemate might stymie the legislative agenda.

To invest, or not to invest?

Ultimately, the decision whether to buy or sell the US will largely depend on your desired weighting in the market.

Mr McDermott says: "If you based this on the global equity benchmark, you would have half your money in the US, whereas UK investors, such as Investors Chronicle readers, will tend to have anything up to 20-25 per cent."

He recommends that a medium-risk investor should have exposure to the US of 10-20 per cent because its weighting in the MSCI World index is around 50 per cent.

As many UK investors have become overweight US equities due to outperformance in recent years, he says it is perfectly sensible for investors to take profits, while rebalancing their portfolios. "There are certainly cheaper markets out there and you can recycle it into something else," he says. "I'm not saying sell because the market is massively overvalued, but, given valuations, I wouldn't buy in now either."

Best funds for US exposure

There is a general consensus among investment experts that it is difficult for active managers to consistently outperform the US benchmark indices. The US is the hardest place in which to find funds that consistently outperform. Mr McDermott says: "If there is one market in the world where one would advocate indexation it would be US large-cap, so any form of S&P 500 tracker."

Passive funds

Investors have a large range of choice here, with the SPDR S&P 500 ETF (SPX5) making it into the Investors Chronicle's Top 50 ETFs in May 2014 as our preferred choice for exposure to the S&P 500 Index. Since then, the ETF's TER has come down from 0.15 per cent to 0.09 per cent. The Vanguard S&P 500 UCITS ETF (VUSA) also has a TER of 0.09 per cent.

Alternatively, you could buy an index tracker fund that aims to reproduce the performance of the S&P 500. Two of the cheapest options are Fidelity Index US W Acc (GB00BLT1YN15) with a TER of 0.10 per cent and HSBC American Index C Acc (GB00B80QG615) with a TER of 0.17 per cent.

Ben Seagar-Scott says that, given his concerns over valuation, an 'alternative beta' approach such as the PowerShares FTSE RAFI US 1000 UCITS ETF (PSRF) might be a good option. This ETF aims to replicate an index that weights US stocks based on their fundamental characteristics of sales, cash flow, dividends and net asset value, rather than their market capitalisation. "This has the effect of giving the ETF a value tilt, which favours strong company fundamentals, rather than a high valuation," he says. The ETF has a TER of 0.39 per cent.

Active funds

Mr McDermott likes AXA Framlington American Growth Z Acc (GB00B5LXGG05). He says it will experience periods when growth is out of favour, "but when growth is in favour this fund does very well." Another pick is JPMorgan US Equity Income C (GB00B3FJQ599), which he says is a "good core holding". He also rates Schroder US Mid Cap Z Acc (GB00B7LDLV43), which invests in companies largely ignored by analysts, so the opportunity to find real winners is much greater.

Mr Gregory recommends Fidelity American W Acc (GB00B8GPC429), run by Peter Kaye, who has been the manager for a year, but who came from Melchior with a strong track record. "Peter invests in high-quality companies with good earnings growth and momentum," he says.

PSigma also invested in the Polar Capital Healthcare Blue Chip Fund (IE00BPRBXV28) at its launch in August. Although not officially a North American fund, it consists largely of US healthcare companies and healthcare service providers. "There are selective places in the US where we're happy to invest and one of these is US healthcare companies. But any investment in stock has got be regarded as long term," Mr Gregory says.

Mr Stevenson likes Smith & Williamson North American Trust B (GB00B40T1C34), which invests in high-quality companies with good management that the managers believe are trading below intrinsic value. "When buying a stock they take the view that they are buying a stake in the underlying business, with a focus on the sustainability of underlying cash flows," he says.

He also rates Old Mutual North American Equity (IE00B8XWX876), managed by a team of co-portfolio managers, led by Ian Heslop, head of the firm's quantitative strategies. "These are combined to meet the fund's aim of performing well in different market environments. The fund is diversified and tends to invest in liquid North American stocks."

Another favourite is JPMorgan US Select (LU0671461233), which is managed by an experienced portfolio management team, headed by Thomas Luddy. The fund is broadly sector neutral and is considered a good core holding because it follows the benchmark relatively closely.

Performance of recommended funds*

Source: Morningstar as at 5 November 2014. *Shows cumulative total returns. Performance data are reported in GBP.