As the S&P 500 reaches its highest point in history, are investors right to be cautious or are there more opportunities?
Is there potential for growth as the S&P 500 reaches new peaks?
The S&P 500 reached its highest point in history earlier this week, advancing over 17% year to date. The index is a proxy for the US market, and is based on the market capitalisations of 500 large companies, representing about 80-85% of the US stock market. A strong US stock market generally translates to a robust US economy. This also boosts the stock markets of many other countries that export to the US and are therefore sensitive to US consumer spending. A number of drivers are thought to have contributed to the recent recovery.
Indicators that the rally will continue
The corporate earnings recession that many had previously feared, failed to materialise. Of the companies that have reported thus far; 77% of companies have beaten the lower expectations, 6% met and 17% missed.
In addition to good company fundamentals being published, data from the US economy has also improved investor sentiment. Gross domestic product grew at an annualised rate of 3.2% in the first three months of the year, beating forecasts. Moreover the strong rebound in retail sales and durable goods orders along with continuing low unemployment levels are a testament to the economy’s resilience.
A strong labour market, real wage growth, increased government spending and an uptick in business investment may point towards a US economy that still has momentum. Furthermore, US-China trade talks have supposedly reached their penultimate round, paving the way for a final agreement between Mr Trump and Xi Jinping to be signed in late May or June. This is likely to positively affect investor sentiment; however a lot of the upside to the trade negotiations may already be priced in.
The role of the Federal Reserve in the equity market rebound
At the start of 2019, the Fed was suggesting several rate hikes may occur this year, which is usually concurrent with a growing economy and attempts to keep inflation in-check. In March it slashed that forecast to no rate hikes for the year. The U-turn by the central bank could have been perceived as an attempt to stimulate a slowing economy, but also could reflect a combination of concerns about international macroeconomics and financial market volatility.
However recent figures show that investors are making record bets on low levels of market volatility after the U-turn in monetary policy helped erase losses from the sell-off at the end of 2018. Large speculators were net short 178,000 Volatility Index (VIX) futures contracts, the biggest bet on record according to the Commodity Futures Trading Commission.
‘Hawkish’ and ‘Dovish’ are terms used to reflect the general sentiment of the central bank, the latter is used as a guard against deflation and usually involves lowering interest rates to encourage more spending on goods and services therefore stimulating the economy. The fed is now faced with the dichotomy of continuing economic growth and below-target inflation, thus many are predicting that interest rates will remain unchanged in this week’s Federal Open Market Committee (FOMC) meeting.
Why there may be cause for concern amongst investors
At 19.3 times earnings, the S&P 500 is currently trading at a multiple that is 7.8% higher than its 10 year average, potentially representing overbought conditions. Despite the better than expected first-quarter earnings, many analysts have persevered in lowering their estimates for the coming quarters.
A persistently strong dollar could begin to negatively impact many large companies with international operations whose foreign earnings will translate into fewer dollars, thus weighing on the US stock market. Recent months have been dominated by higher US equity prices and dollar outperformance, the coming months could test this.
The inversion of the three-month and 10-year yield curve in March caused trepidation amongst investors. The US yield curve is the premium demanded by investors to hold longer-term debt over shorter-dated paper. A flat or inverting yield curve is often a harbinger of recession. Flat yield curves also hurt profitability of financial institutions, which make money by borrowing at short-term rates and lending at longer rates. Yet the S&P 500 financial sector gained 8.8% in April, the biggest one month advance for financials since November 2016.
According to research by Swiss private bank Pictet, the yield curve inverts 18 months before a recession. Taking this into consideration, there is some hope the equity rally we’ve witnessed so far this year may have further to run yet. Moreover, a number of economists and investors are now beginning to price in the possibility of rate cuts this year, potentially providing a boost to the equites market and an extension of the already long economic cycle.
If you believe the signals from the bond market:
Diversification is especially important during market turmoil, minimising risk and protecting or setting aside capital to invest during recovery is paramount. The following funds could help with this:
ETFS Gold Bullion Securities – Gold is typically negatively correlated to equity markets so it can diversify a portfolio and protect against inflation. In general gold starts to look attractive when markets weaken as investors look for safe havens. If an investor held this ETF from the start of 2008 to the end of 2009 they would have made a 55.44% return. The fund also has a low annual cost of 0.4%.
M&G Global Government Bond – The fund aims to deliver income and capital growth by investing at least 70% of the portfolio in investment grade global government bonds. Set to benefit if investors embark on a flight to quality as a result of gloomy global macroeconomic signals, which in turn pushes up bond prices. Over the same period the fund grew 39.08%, which is very strong for a fixed income investment.
If you think the Bull has further to run:
There are a number of proponents that support the continued strength of the US economy. Moreover, immediately after the inversion of the yield curve, market performance tends to be positive, as we have seen this year already. The following funds could continue to benefit if sentiment improves further and the business cycle is extended:
Fundsmith – This is a very concentrated fund likely to be more defensive than some of its peers due to the non-cyclicality of the underlying holdings. It focusses on high-quality global businesses that can sustain a high return on capital employed and deliver strong free cash flow yields. The bottom-up stock research helps to identify companies with significant financial strength and 65% of the portfolio is exposed to American equities.
T. Rowe Price US Large Cap Growth Equity – The strategy is well-positioned to capitalise on market fluctuations and analysts’ ideas compared to its more diversified large cap siblings. It employs a well-executed approach in seeking companies with strong earnings potential over the next three years. Furthermore, the addition of a few defensive names to the portfolio provided some downside protection in the equity market sell-off.
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