Indeed, among the most noteworthy financial market outcomes of 2005 is the resilience of US stocks in the face of 13 consecutive rate hikes by the Federal Reserve. Further, something special is afoot with corporate earnings. Profits as a percentage of GDP, after tax, are higher than at any point since World War II, and profits reinforce the market’s resilience.
However, with its trajectory tapering markedly from its initial liquidity fuelled recovery in 2003, investment strategy should not be built around the notion that 2006 will be a strong year for the US stock market.
The reasons for caution are numerous. Firstly, the S&P 500 remains in the most expensive quintile of its historical valuation range. History suggests that when the market is expensive, do not expect multiple expansion. Without multiple expansion, the upside for US stocks is limited by the pace of corporate earnings growth. An even-tempered reckoning of earnings prospects suggests caution here too. Yes, earnings for corporate America have been booming, but earnings are notoriously mean reverting, particularly in the context of a slowing rate of economic expansion, relentless policy tightening, and a flat yield curve.
As in 2005, investors in US stocks this year should expect active strategies to prevail versus the bellwether indices. Successful active strategies in 2006, will benefit when investors relax their suspicion regarding profits. Companies with high return on equity (ROE) today do not command premium valuations versus low ROE companies. They should, and will again when investors lose their distrust of US profits. From a sector standpoint, energy stocks remain attractive, while the flat yield curve is putting a squeeze on profits among banks, a likely underperformer.
Forget the old advice of big, passive allocations to US stocks. Instead, a comprehensively diversified investment strategy utilising actively managed US stock strategies makes more sense in today’s environment.
Conservative, diversified strategies have delivered competitive returns to US stocks with lower risk in recent years. It seems unnecessary and imprudent to build a portfolio around the notion that 2006 will be a blockbuster year for US stocks. It is better to prepare for disappointment and be pleasantly surprised than the opposite.
Jeffrey Knight, managing director, chief investment officer, global asset allocation, Putnam Investments.
Knight: active strategies to prevail
