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Created:
30 June 2006

It is the world's most powerful economy, with a history of stock-market gains that is second to none. What a shame, then, that the US's past profits cannot guarantee future ones.

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In fact, right now, US investors are divided and nervous about whether inflation and rising interest rates are around the corner. These are the fears that have fuelled the recent slide in the major stock markets and indices around the world. But, for all the uncertain outlook, the US market cannot be ignored.

So the big questions now are:

  • Has this summer's market correction created an opportunity to invest in the US?
  • Does the US stock market represent good value compared with other global markets?
  • Will it will continue to grow at competitive levels?

As always, by the time we know for sure, the investment opportunity will have gone. Still, as a UK-based investor, a direct investment in the US can provide some diversification in terms of geography, currency, economy and sectors - as well as the comparative safety of investing in a large, successful economy.

"It's the biggest, and most liquid and most diverse market of all stock markets in the world - you can play any theme you like," says Felix Wintle, the head of US equities at Neptune Investment Management. He uses bird 'flu as an example.

You can short poultry farms, go long on pork farms, invest in drug companies developing vaccines and whatever else you can think of.

But, perhaps more importantly, this market is home to some of the world's largest corporations, including Goldman Sachs, Microsoft and Wal-Mart, which have businesses that reach around the world.

"The US is still the biggest economy is the world, and will be so for many years to come," he says. "One of the reasons we like investing in the US is that we believe in the globalisation story, and one of the best ways into that is not to invest in risky developing markets, but by investing in the US markets."

If you then consider comparative valuations at an index level alongside that, the outlook doesn't look bad. "I'm still comfortable because earnings growth prospects - both historic and prospective - are solid,"  says Katherine Collins, Fidelity International portfolio manager. "So US stocks have slightly higher valuations than most other geographic regions, but also somewhat better growth prospects."

"In fact, on certain measures, the US market looks cheaper compared with other regions than it has for 15 to 20 years. And there is generally more diversification within the US economy and stock market than other areas. That's a very interesting backdrop for investors."

The US is cheapOther measures of stock-market valuation support Ms Collins' view. The S&P 500 trades on a relatively low forward price-earnings (PE) ratio of 16.7 times, and the Dow Jones on 20.4 times.

So Merrill Lynch's latest fund manager survey found that a net 28 per cent of asset allocators expect to increase their weighting in US equities over the next year. Foreign buying of US assets is not always a good omen, though (see Chris Dillow's analysis of overseas buying).

Nevertheless, Citigroup strategist Tobias Levkovich estimates that the percentage of stocks trading at, or below, their 200-day moving average is now hovering at about 60 per cent. That is below the highs reached after the terrorist attacks of 11 September 2001, but higher than previous corrections in 2004 and 2005.

In terms of currency diversification, most funds simply recommend that you ride the ups along with the downs, although they say they will employ hedging if there is a clear depreciation trend emerging in the dollar. If you're keen to play the currency, too, there are funds that take investments in currencies other than sterling, usually domiciled outside the UK.

Mixed signalsHowever, there are still a few issues clouding this straightforward analysis. At the forefront of most investors' minds are the next few moves by the US Federal Reserve. Investors believe that much of the market's present weakness stems from uncertainty about rate rises. In fact, since his appointment, US Federal Reserve chairman Ben Bernanke has been criticised for sending confused signals about the direction of interest rates.

In April, he gave the false impression that the Fed was about to stop raising interest rates, so encouraging markets to run harder. He and his fellow Fed officials then tried to counter this impression by suggesting that inflation was higher than they would like, and later confused the issue again by  expressing confidence in the economy's ability to withstand higher oil prices. This foggy outlook for rates prompted a flight from 'risky' stocks, including small-caps, cyclicals and high-growth sectors.

Terry Ewing, a portfolio manager at Old Mutual Asset Managers, admits that, while he has a positive outlook on the US stock market, he is cautious about the impact of rate uncertainty. "We are somewhat wary of Mr Bernanke and his performance since taking over the Fed, and we don't really like the mixed messages he has at times been sending out about the outlook for interest rates, and the tone of Fed policy surrounding it," he says.

This is a view echoed by Gil Knight, a senior fund manager at Gartmore: "Longer term, we're fairly positive, but there has been enough indecision and confusion on the part of global equity markets and central banks that it pays to be a little  conservative." Mr Knight currently describes his position as "market neutral", and is sitting on the highest cash levels he has had in three years.

Investment opportunitiesUnderpinning both fund managers' belief that the US stock markets will provide good investment opportunities are several factors. Corporate balance sheets are strong, dividends are growing at about 15 per cent, while earnings growth is on track for double digits this year, even taking into account a moderation over the next six months. After the Enron and WorldCom scandals, a new conservatism has entered US boardrooms, so analysts are confident that most companies will meet - and even beat - their earnings guidance. And, for the past three years, PE ratios have fallen on average. Drill down a little further, though, and that's not universally the case.

The stock market's current gyrations have made investments in large-cap, lower -risk stocks the most popular play at the moment. Morningstar's head of fund analysis, Christopher Traulsen, agrees that large-caps are in fashion, and notes that they typically carry less risk and give good core exposure. Ms Collins adds that large-cap, high-quality companies now trade on the same level as a high-risk, smaller company. She attributes this to the extended low market volatility which has gradually compressed risk adjustment. But, within this, there are some things to look out for.

Mr Traulsen says that investors should be picky, and steer clear of funds that have been too heavily weighted towards outperforming sectors. "If you're an investor looking to get in to the US at this time, avoid what has already done extremely well [such as small and mid-caps, energy, industrials and commodities]," he says.

In the past 12 months, the top performers by sector on the S&P 500 were steel at 90.5 per cent, agricultural products at 82.5 per cent, and diversified metals and mining at 57.45 per cent. Other strong performers have included oil and gas equipment and services, railroads, construction and engineering, and human resources and employment services. As a result, during the same period, the S&P 500 rose 2.3 per cent, the Dow Jones 3.5 per cent and the Nasdaq 1.3 per cent, excluding dividend reinvestment.

Most investors now agree that small-caps are too expensive, particularly when the current rate environment is added to the picture.

But not all are willing to write off small and mid-cap stocks. Mr Knight says there is scope for a further de-rating, particular in the small-cap sector, but he adds that the real beneficiaries of certainty in the Fed’s policy are also likely to be in this sector.

"If we're right, and we're looking for a much better fourth quarter, we think you want to be in small and mid-cap stocks again," he says. "I don't think they've corrected enough. But, at some point, they will have, and at some point you will want to take another look at them. In the US, historically, when the Fed has eased, it's always been the small and mid-cap stocks that have outperformed."

Mr Ewing, who is overweight in mid-cap stocks, puts it more bluntly: "Typically, you find the best time to make some decent money is when people are nervous."

In terms of sectors, Mr Wintle has an interesting perspective. "We have a view that the industrials, although still cyclical, have lost a lot of cyclical attributes because there has been a massive upswing in demand from developing countries and internally within the US in terms of infrastructure spends," he explains.

"These companies have been basically transformed, they've got order backlogs that run for many years and never seen anything like it."

Within industrials, then, three fund managers believe the commercial aerospace sector has a strong capacity for growth.

Click here to download a list of the top 50 US funds as ranked by Standard & Poor’s by three-year performance (as a PDF file)

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