10/06/06
Fundamentals - The US Equity Market
Jesse Livermore, the great Wall Street trader, said famously that "in a bear market all stocks go down and in a bull market they go up". With a US equity market rally that has (so far…) lasted over 3 years and has posted a 55% return, it is evident that during this bull run that adage has not necessarily held true.
An interesting feature of this strong equity market performance over the last few years has been the composition of those returns. Unlike the market conditions that were experienced in the late 1990s – when it was the "new economy" of information technology and communications companies that excited investors – the stocks that have performed best over the last few years have been unashamedly "old economy". Moreover, they have not necessarily taken the rest of the market with them.
Looking at the recent returns of the S&P500, economic sectors shed more light on this. Over the last two years the best returning sectors have been those of Energy (+70%), Utilities (+37%), Materials (+28%) and Industrials (+25%). By contrast the IT sector has provided uninspiring returns (+2%) and the Healthcare sector has done even worse (-1%). When analysing which stocks have been the key contributors to market performance it is also clear that the rally has not been as widespread as Livermore would have had us believe. Of the top 20 S&P500 performers of the last two years, only Apple sits within the Technology sector. The index leaders were inevitably those exposed to the well-documented rise in commodity prices: oil services companies (Transocean, Baker Hughes, Halliburton), steel companies (Allegheny and Nucor) and commodity related utilities (TXU) and elsewhere in the industrial sectors other companies have also seen their market value increase by more than 50% over the period. Companies like Caterpillar, United Technology, Rockwell Automation and Johnson Controls, all makers of industrial parts, along with railroad stocks (Burlington North, CSX, Norfolk Southern) have all been star performers.
These stellar returns have in large been driven by the industrialisation of China and the continued strength of the US economy, leading to strong demand for both commodities and industrial equipment. This has boosted sales for these "old economy" companies. What has also been important is the ability of these management teams to turn these sales into profits and cash flow by keeping a tight reign on expenses and capital spending. By focusing on internal efficiencies, at the same time as they have been experiencing robust external demand, profitability margins have improved markedly. It has been this level of earnings generation that has excited investors. The market has priced up the shares of these companies as they become more profitable, rather than necessarily paying a higher price-earnings multiple for these earnings. It is this feature – an earnings-driven rally rather than a market re-rating – that has caused such disparity in stock and sector performance.
To better understand this, we also need to look at the other end of the spectrum. Many of the large technology companies have had a tough few years. Profitability has actually suffered as they have faced mounting competition in largely over-supplied markets, resulting in reduced pricing-power and lower margins. Technology giants like Microsoft, Intel, Dell, IBM and Cisco have all experienced these difficult conditions, in sharp contrast to their industrial peers. The impact on their share prices has been compounded as investors downgraded their expectations of how fast these companies can grow, hitting the price-earnings multiple that the market is willing to pay. The net effect has been that all five of these companies have actually seen their share prices fall over the last two years.
So, while we may well be in the internet age and this may be the first World Cup that we can watch on our new mobile phones, investors in the US equity market over the last couple of years would have done well to ignore Jesse's advice and distinguish between the "old" and the "new" through this bull run.
Stephen Weeple, Head of US Equities, Standard Life Investments
First published in The Herald on 10 June 2006
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