Fourth of July: celebrate responsibly


Investors in US equities have cause to celebrate on the fourth of July but should be alert to danger signals, and seek a balanced style of investment, argues Ian Heslop, manager of the Old Mutual North American Equity Fund at Old Mutual Global Investors

As the US celebrates Independence Day, investors can be delighted with the long-term performance of its stock market. Over the past 10 years – a period that includes the Great Financial Crisis of 2008 – the S&P 500 has a total return of 100.0% – doubling your money, in other words, if you had reinvested dividends. Measured on the same basis, the MSCI World Index returned 56.8%. The returns for sterling-based investors – whose returns are flattered by the weakness of the pound - are even better: a total return of 208.6% from the S&P 500 over 10 years (more than tripling your money). Investors certainly cannot ignore US equities.

The question is often asked whether, given their prolonged success, US equities have now become overvalued. US equities are certainly on relatively high valuation ratios. The price to book ratio of the S&P 500 has risen steadily over recent years, and is currently 3.1 (compared to 2.4 for the MSCI World).

One warning note is sounded by the bond market. Whereas valuation ratios of US equities have continued to rise, US bond yields have weakened this year. Yields rallied sharply in expectation of fiscal stimulation and higher interest rates during the initial enthusiasm which greeted the new administration after Donald Trump’s election victory on 8 November 2016, but fell back as investors became more sceptical. Campaign promises have been thwarted by opposition in Congress - despite a Republican majority in both houses.

Within equities, during the latter half of last year, the dominant investment style was value (meaning that relatively cheap stocks, such as financials, outperformed), whereas this year the value trade has faded and the dominant style has been growth (meaning faster growing companies have outperformed). This year’s darlings have been information technology stocks, such as Apple, Amazon, Facebook, Netflix, and Nvidia. Over recent weeks, however, technology stocks have suffered several market wobbles, which may sound a second note of warning.  

Investors should not ignore US equities, but I would urge caution about the overuse of passives (ETFs and index trackers) when investing in them. The top 10 stocks in the S&P 500 account for 2% of its number of stocks but currently a whopping 20% of its market capitalisation. It is possible that this top-heaviness has partly resulted from the large inflows that passives have attracted. Investors who put their money into passives tracking US equities may now be taking on a degree of risk they had not anticipated. We are not predicting a sharp market fall, but if a correction were to occur, some of the top stocks – which include many technology names – could be among the sharpest fallers. The correct approach, we maintain, is diversification, and a balanced approach to investment style.

That is why we set out to find diversified sources of alpha. Our stock selection process utilises a variety of independent, but complementary techniques. Our investment process dynamically weights each of our five stock selection criteria according to how profitable we expect it to be in the current market environment. We believe this is a sound way of aiming at consistent returns despite changes in the market.