Investors still cautious on US market despite reaching all-time high in June

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25 June 2007

Despite nearing an all-time high earlier this month, many US investors remain cautious on the outlook for the US market.

In fact investors have actually been quite bearish for the last two years despite the ongoing strength in US equities over this time period. Admittedly it has been over seven years since the market peaked in March 2000, so it is perhaps no wonder that many remain sceptical of the recent bull market.

Domestic US investors have shunned the US market in favour of international equities.

Much of this money is being invested in the emerging markets of Latin America, the Far East, and Eastern Europe. In performance terms, this has been the correct thing to do. In fact, most international markets, developed and emerging, have appreciated far more than the US over the period and the weakness of the US dollar has compounded those differences further.

The vast majority of buying in the US market has been through corporate share buybacks or through acquisitions. Acquisition activity is at extreme levels and has far exceeded previous records. Companies have been able to engage in such aggressive activity because balance sheets are generally very healthy after several years of exceptional profit growth.

The fact that so many acquisitions have been funded by cash, rather than issuing new shares, is important as they generally create better value for shareholders of the acquired company. On a short term basis it also helps the market, as it provides a valuation floor and shrinks the supply of equity. This has been a common theme throughout the world.

Ultimately the market will only experience a sustained rise if valuation and fundamentals are both attractive. While recent macroeconomic data have suggested that the economy is on track to grow at a steady but uninspiring 2.0%-2.5%, the prospect of higher inflation remains the primary risk.

There are no indications that the US economy will fall into a recession but we do feel that higher than anticipated inflation may see interest rates stay higher for longer. The market is also looking expensive with the median forward PE of the S&P 500 at about 17 times on peak margins, but supported by strong balance sheets.

Bull Points

• Significant acquisition activity
• Steady economic growth

Bear Points

• Inflation risk
• Weak dollar

James Kinghorn
Senior Investment Manager
The Scottish Investment Trust PLC

Published in Investment Week

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