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4 September 2006

Headline performance is not all it seems

“The market’s performance masks a significant deterioration in investor sentiment”

The S&P 500 has made a significant recovery since the small correction that bottomed in early June. The market has risen over 6% since then and is less than 2% off the five-year highs at the beginning of May. It would appear that previous investor concerns regarding inflation and economic growth have eased.

The market’s performance, however, masks a significant deterioration in investor sentiment. This is clear when comparing the performance of the S&P 500 to that of the mid- and small-cap indices. They have not rebounded and have, in fact, continued to decline, reaching year-lows in late July. Both are down nearly 10% since their peaks in early May. Larger stocks are typically seen as more defensive in periods of uncertainty and there has been a clear rotation out of mid- and small-cap firms.

Industry performance also confirms a move, by investors, to more defensive positions. Over the past three months the best-performing industries have been utilities, telecommunications services, pharmaceuticals, tobacco and food and drug retailers, all traditionally defensive sectors.

The weaker performing industries have been very cyclical, in particular basic materials and industrials, old market leaders.

Similarly, the appetite for international markets has faded. In the past three years US investors have been large buyers of international equities. There are indications that this has reversed and large-cap domestic stocks are the first place investors typically rotate into.

The headline index performance therefore masks ongoing investor concerns regarding inflation, interest rates and economic growth. While this uncertainty continues, we feel the market will be confined to a trading range. Current market levels are near the high end of this range so we could see further corrections until there is more visibility on the health of the economy.

While market valuations are not particularly challenging, our concern stems from declining liquidity after several Fed rate rises. Market multiples tend to fall in this environment, particularly if earnings estimates are being revised down, as we believe will be the case later in the year.

Consensus estimates for next year suggesting more double-digit earnings growth look too optimistic given declining economic growth and potential profit margin pressure. We believe that profit growth in the mid single-digit range is more realistic.

We have made several defensive shifts of late, adding to our position in the pharmaceutical and biotechnology sector through Endo Pharmaceutical and Amgen, both are good value and have solid growth prospects.

We still have exposure to industrials, largely through transportation stocks that look oversold after the recent correction. We have also increased our position in energy equipment at the expense of exploration and production exposed names, as we feel there remains a strong secular growth story here.

We remain wary on consumer-related names as it may get worse before it gets better as oil prices and interest rates hurt discretionary spending. The housing market also looks vulnerable and will have a negative effect on consumer spending. Although valuations for many retailers are starting to look more interesting, we feel it is too early to take aggressive positions at this time.

Bull Points

• Valuation support
• Rotation into domestic equities
• Earnings still growing

Bear Points

• Earnings estimates too high
• Falling liquidity
• Macroeconomic uncertainty

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

Published in Investment Week

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