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US Equity Strategy: 4Q 2013

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US Equity Strategy Review:

Heading into year-end is a good time to take stock of the US market’s performance and remind ourselves of the generic but key drivers of overall stock market performance.

The quick summation of the US equity markets strong performance for 2013 (year to date) is that it has been driven by the return of the retail investor, increased use of leverage among individual investors, increased fund flows into equity mutual funds and a willingness from some segments of the market to pay up for equity assets irrespective of the un remarkable earnings growth displayed by US companies.

To recap:

The US stock market rallies to new all-time high in the fourth quarter of the year. The push up came in following the late summer scare over withdrawing stimulus by the US Fed.


Stock market buoyancy reflected signs of macro stability and the expectation of stronger earnings growth ahead. Macro indicators are stable though not exceptional despite record liquidity and low short term rates. US retail sales flat lined (see Chart 2) after recovering from post-recession lows even as personal savings are up post-recession (from 2008-09) to 4.8% of GDP (from 2.0%-3.0% pre- recession), though average hours worked (an important indicator of consumer health) improved steadily.

The auto sector is a key exception to the caution shown by US consumers (as reflected in the above retail sales) and annualized sales are at 16.1 million vehicles. The chart below shows actual monthly sales since 2007 and reflects both the sharp fall as well as the recovery. For all of 2013 the US has seen sales of over 1.0 million vehicles a month, with average sales of 1.4 million vehicles a month.


US corporate earnings growth remains within long term averages for the S&P500 but the price earnings (PE) multiple has moved to above average territory. Earnings per share (EPS) growth for constituent companies in the S&P500 index for 2013 has been around 6% but the index has produced a 28% appreciation (through to the first week of December) so most of the gains have come from multiple expansion. Most of the average stock price growth between 2009 and 2011 came from the recovery in earnings, while the period from 2011-2013 saw an expansion in the multiple applied to future earnings.



Going forward it is hard to see too much more multiple expansion without reacceleration in earnings growth. It is important to keep in mind that earnings growth and stock prices have a linear relationship over the long term. Over the last 20 years the S&P 500 has grown by 9% vs Earnings Per Share growth for the S&P500 of 7%.

But here is the key driver behind the recent multiple expansion in the stock markets – margin finance at US brokers are at an all-time high and very likely linked to the return of the individual investor as are the growing inflows into retail equity mutual funds. Retail investors flocking back to the market is usually taken to be a contrarian sign.


The figure below plots the inflows into different asset classes in the US over the past year. Note the surge into equity mutual funds (left hand side of the bar chart).


So even though we have had significant inflows into equity funds in the US, coupled with all time high leverage we need to see a reacceleration of corporate earnings growth for the stock market to justify a move higher. This is a significant challenge to the performance of US equity markets for 2014 and it is unlikely that we will see a repeat of 2013.




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