Whether or not 2006 can produce a similar, or better and broader, rally depends on the economy. However, investor sentiment could be quick to sour on any signs of a significant economic slowdown.
Recent economic data gives reason for optimism, however. February brought news of strong retail sales, as well as the largest gain in housing starts in 32 years. While this may in part reflect seasonal/weather factors, continued low unemployment and an improving business investment backdrop supported the trend.
To what extent will all this be good news for US GDP? While growth should improve from 2005’s tepid fourth quarter, when GDP rose only 1.1 per cent, it is doubtful whether the economy can outdo its growth in the past two years, when it expanded about 4.3 per cent on an annualised basis.
On the assumption that higher energy costs and rising interest rates will adversely affect GDP growth, caution is advised on US small caps. Small-cap stocks typically outperform during the early phases of an economic expansion. Indeed, smaller stocks outperformed large caps for a record seven years running through 2004.
Relative valuations are noteworthy in this context. Valuations on US small caps relative to large caps have reached historically high levels. The price/earnings multiple on the Russell 2000 Index, a measure of smaller US companies, now has a 40 per cent premium over the S&P 500 Index’s price earnings multiple of 16, based on 2006 estimated earnings, a gap that perhaps leaves smaller stocks less attractive relative to larger companies than they have been.
Still, the underperformance of small caps in 2006 is not a foregone conclusion. The primary small-cap positive in the current scenario relates to earnings growth. The expected earnings growth rate gap between small and large companies is also historically wide with 25 per cent for the Russell 2000 Index versus 8 per cent for the companies in the S&P 500 in 2006.
This suggests that companies able to deliver above average growth in the slow growth environment – growth stocks (both small and large) – will command premium price/earnings multiples.
Stephen Kaszynski, head of US equities at Credit Suisse Asset Management.
