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05 September 2005

High energy costs mean struggle ahead

“Oil prices are 50% higher than a year ago and there is little to suggest prices will ease”.

This year the S&P 500 has struggled to make any ground, rising just 1%, or 8% in sterling terms, despite reaching four-year highs in early July. The market is up over 50% from the October 2002 low but is still down over 20% from its all-time high reached in March 2000.

This is in contrast to the S&P's mid-capitalisation and small-cap indices, the S&P 400 and S&P 600, which both reached all-time highs at the beginning of August and are up over 40% since the technology bubble burst in March 2000.

The energy sector has been a key contributor to earnings growth and has been by far the best performing sector rising 28% this year, helped by high oil prices.

High energy prices are one of the main reasons the market has struggled to make any headway. Oil prices are now 50% higher than a year ago and, given the supply and demand imbalances in the global oil market, there is little to suggest that prices will ease. This has implications for the whole economy but it is typically consumer spending that is hit hardest.

Another recent issue for investors has been a fear that economic growth and inflation trends are re-accelerating and that subsequent interest rate hikes will restrain the market.

Inflation, at least ex-energy, remains benign, but indicators suggest the Fed will continue its pace of interest rate hikes. Current expectations are for another 75 basis points in the next 6 months but it seems unlikely they will stop at 4.25% unless there are clear signs of an economic slowdown.

Looking ahead, the earnings prospects for the US market still seem solid. Industrial activity indicators are positive, the recent Institute for Supply Management (ISM) new orders and consumer expectations both had strong readings and low inventory levels bode well. Corporate spending should rise further given corporate America's healthy balance sheet and free cashflow yield. One concern is that forecast earnings for 2006 may already be too high and this could lead to disappointments.

In the context of its own history, the market does not look overvalued on a price-to-earnings and price-to-cashflow basis, particularly given modest inflation.

Strong balance sheets will provide support as high cash balances tend to lead to greater share repurchase activity and cash funded acquisitions that both add considerable value to investors. Other readings such as insider selling and investor sentiment, the latter a contrarian indicator, are also positive.

The preference for small over large caps is ending. Small companies trade at a 10% premium and economic data and earnings trends suggest growth superiority is likely to falter. Our own preference is for mid-caps.

Growth stocks look more attractive than value stocks and trade at about a 10% PE discount to its historical norm. Similarly high-quality companies look better value than low-quality given they are trading at a 15% discount to low-quality stocks on a PE basis and outperform when earnings growth slows.

We have been reducing utilities and consumer staples and have no exposure to the telecommunication and materials sectors in the US. We still like selective names in the industrial sector but, despite renewed economic strength, we are not being too aggressive, given valuations there. We have added to technology and select financial names and remain heavy in energy and non-pharmaceutical healthcare stocks.

James Kinghorn
Investment Manager, US equities
The Scottish Investment Trust PLC

Published in Investment Week

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