This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Don San Jose, manager of JPMorgan US Smaller Companies Investment Trust, predicts great growth for the US.
As the US equity market flirts with new highs, we continue to believe that equities can go higher. Stocks look fairly valued to us and we would expect that investors will still earn a reasonable return from these levels.
The relative valuation gap between equities and fixed income remains intact and for us could be a key catalyst for equity performance from some asset class rotation.
Additionally, there is enough growth in the US to keep earnings moving ahead. While year-over-year earnings growth will be slower than we have seen in the recovery phase that started in 2009, it is still positive growth. This will also be supportive for equity markets to move higher.
A continuation of the economic recovery with many of the domestic headwinds becoming tailwinds is a positive, hopefully lifting investor psychology. One thing we are not seeing is ‘irrational exuberance.’ The crisis is still very fresh in people’s minds. Companies, governments and consumers are all being more prudent and disciplined with their cash, and all of that tells us that this recovery still has more legs.
We recognise that uncertainties, particularly in January and February as the debt ceiling and budget negotiations resume, could create noise in the nearer term. However, overall we think the market will trend higher.
But we do still have some significant longer-term challenges in America, and in many other developed countries as well, around how the government is going to resolve the long-term imbalance between spending and income. Those are not issues necessarily for the coming year. But they are going to be issues for the next five to 10 years - and they will be issues for the next generation, too. There is still time to make the right decisions and put things on a sounder track. However, the clock is ticking and we don't have an infinite amount of time.
Investment Themes
From a macro perspective, the housing theme has been a strong performer for most of the year, although there was a bit of a blip on the prospect of rate rises recently. However, it’s important to understand that the housing market crash was far deeper than those we have seen previously, so there should still be several more years of recovery. Smaller companies tend to be more US-levered and have a high correlation to the housing market, so they are a good way to play both the housing and domestic economic recovery.
With less overwhelming macro trends, company fundamentals should emerge as critical factors in driving stock performance. We remain focused on finding companies with durable franchises, good management teams and stable earnings that trade at a discount to their intrinsic value.
Value Judgments
On an absolute basis I would say the market is fairly valued relative to the historical average. However, the comparisons with bonds still look flattering, and we don’t see too many signs of excess or speculation in the stock market. Our research work suggests that the current record level of profitability for American companies is sustainable, which is of course the critical assumption. The long-term structural benefits of globalisation (lower production costs, new markets and limited new competition) are making this a great time for many companies, especially in manufacturing and technology.
One of the goals of every valuation-orientated investor is to avoid value traps. None of us wants to buy a cheap stock and have it get cheaper. The current market rally is very broad-based with data suggesting it is the broadest market rally in over 35 years. As a result there are not many value traps as the rising tide has lifted all boats. Unfortunately some boats have been lifted too high and we are seeing some pockets of excess in the quest for yield and stability. On a sector basis, utilities, consumer staples, REITs and telecoms look expensive.
We expect in the next year to see the benefits of a slightly faster economic recovery in the profits of many consumer and financial companies. So earnings should continue to grow, while very strong cash flows and a conservative attitude to capital spending should see dividends again rise at a faster rate.
This is all very supportive of further gains in stock prices, albeit at a slower pace and with the occasional episodes of volatility that are an inevitable fact of life for equity investors.
