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3 December 2007

Several reasons to remain cautious, but investment opportunities remain

US stock market investors have increasing reasons to be cautious. Although the S&P 500 Index recently came off an all-time high in early October, the US has been one of the weakest performing equity markets in the world when adjusted for currency. In sterling terms, the US was the second weakest market over the past 12 months, just ahead of Japan, and the weakest over five years.

Valuation is a key factor. Global equity market P/E multiples have converged in the past five years. The US market traded at a large premium to other regions, but this has disappeared. Strong US earnings have been rewarded by higher share prices but the absolute P/E has fallen.

The other factor has been the weak dollar which has been depreciating since 2001. In the past 18 months, the dollar has fallen significantly against sterling. Real GDP in the third quarter was up a respectable 2.6% over the same period in 2006, but the previous two quarters were far weaker. Rising inflation remains a threat to economic growth, despite relatively benign recent inflation figures.

Commodity prices (oil, metals, and food) have risen substantially, and wage inflation has hovered at 4% since early 2006. Food and energy inflation, often ignored because of volatility, has increased to over 5% in the past three years. The growth in global demand for these commodities may mean sustained high prices.

The problem is that most of negative economic news is specific to the US currently. The sharp decline in the US housing market and the credit squeeze from the sub-prime mortgage market are likely to be a drag on US growth for several quarters.

This shows the US as one of the slowest-growing economies in the next 12 months. However, many companies are still generating very strong earnings growth; the weak dollar and strong growth in many international markets have helped firms with significant foreign exposure to deliver healthy results.

So there are still good investment opportunities. Another positive note is the Federal Reserve's quick and aggressive response to recent problems in the credit market with two interest rate cuts to 4.5%.

Caution is wise given the current problems, and we would avoid financial and consumer discretionary companies as well as industrial names with US-only exposure. We remain very positive on the energy sector, particularly equipment and service companies, and see value in select stocks in the telecommunications, health care, and technology sectors.

Bull Points

• Interest rate cuts
• International earnings growth

Bear Points

• Slow economic growth
• Rising inflation

James Kinghorn
Senior Investment Manager
The Scottish Investment Trust PLC

Published in Investment Week

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