While the major US stock markets have consolidated recently, profits can still be made from taking advantage of opportunities generated by adverse market sentiment and buying oversold companies
The mood of triumphalism characterising American foreign policy does not seem to have reached investors in the world's leading stock market. Although it has bounced decisively from the low point of 21 September 2001 (S&P 500 +14%, Dow +18%), the past few months have seen consolidation rather than advance, with volatility again reaching extreme levels.
After the shortest recession in recent history and the pattern of economic data pointing decisively to stronger growth later in the year, the scene should be set for a further advance. But the players seem reluctant to follow the script. What will persuade them to fall in line?
Having been the object of extensive doubt over deflation and double-dip recession, the balance of economic data is signalling a consumer-led cyclical upturn. Economists are upgrading their forecasts, with the optimists implying annualised rates of more than 3% by the second half of the year.
This is hardly a surprise, given the combined stimuli of lower interest rates, rising money supply and higher government spending. Any other response might have heralded more serious problems.
Companies have responded to tougher trading conditions by reducing inventories and accelerating restructuring programmes, thereby maintaining productivity gains. After the sharp deterioration in profits last year, some recovery seemed inevitable. There is now scope for profit upgrades as the year progresses, a direct contrast to the relentless deterioration in 2001 that so unnerved investors. This suggests that the corporate newsflow should become more hopeful.
While January was always likely to be an important month, few commentators could have predicted quite how eventful it would turn out to be. Enron was undoubtedly a show spoiler, large enough in its own right to create a tidal wave but also enough to set off serious doubts about company accounts in general.
In such a feverish environment, any suspect is fair game; it was unfortunate for Tyco and Elan (actually an Irish company) that they were the sacrificial offerings. Throw in a few corporate defaults and investor risk aversion, a key theme in 2001, returns to centre stage.
What is most striking is the return of extreme volatility to the stock market, a feature that is both alarming and a source of great opportunity to investors with nerve and conviction.
The company reporting season was mixed rather than wholly pessimistic, with managements generally unwilling or unable to outline a more optimistic view. Perhaps the fact that directors are overwhelmingly sellers rather than buyers of their own shares was enough to maintain caution on Wall Street.
We expect the tone of company comments to be more optimistic over successive quarters of 2002, a gradual momentum typical of the early stage of an economic cycle. Momentum will need to be strong enough to counter the lack of overall valuation support, as evidenced by current year price earnings ratio of more than 25 and yield of 1.2% on the S&P 500 Index. Moreover, in contrast to the position in Europe, the equities are no more than neutral value against bonds. This background does not seem especially promising but fortunately it does tell the whole story. Even if the main equity indices on Wall Street struggle to make progress this year, there is plenty of scope to profit by taking advantage of market polarisation, the wide valuation spectrum and the abundance of anomalies on offer.
At the very least, 2002 promises to be a great year for traders and hedge funds. Above all, market conditions are well suited to an active thematic approach. Passive funds or closet index trackers, which are a major force in the fund management business, are likely to experience another tough year.
Our choice of favoured themes is generally the product of bottom-up stock selection rather than a macroeconomic asset allocation approach. We are looking to buy good quality companies on valuations that do not reflect their prospects or potential. This often means taking advantage of opportunities generated by adverse market sentiment and being prepared to buy oversold companies that other investors are shunning. Recent examples in this category include AOL, AT&T Wireless and WorldCom.
These decisions are backed by a considered, research-based approach, combining the knowledge base of our specialist global team and a willingness to follow our convictions.
In sector terms, we are overweight in consumer cyclicals, consumer staples, financials, healthcare and materials. Even here our choices are highly stock specific. In financials for example, we currently believe that certain investment and commercial banks offer outstanding value.
Stocks like Merrill Lynch and JP Morgan are reflected their recent dire experience rather than the recovery potential likely from a revival in revenue on a slimmed-down cost base. Fleet Boston also looks grossly undervalued.
We are equally selective in healthcare, being neutral on pharmaceuticals (apart from American Home Products and Pfizer) but overweight in hospitals and HMOs. Among consumer companies, we would single out autos (especially Ford), retailers (like Sears and Tiffany), and tobacco (Philip Morris).
Areas in which we are underweight include energy, technology and utilities. Our caution on the oil price largely determines our preference for mining stocks as the way to play the economic recovery theme in resources.
Controls over production are far tighter among mining companies, where consolidation and rationalisation has largely eliminated the thirst to build surplus capacity at the top of the cycle. Despite the best endeavours of the oil majors, lack of discipline among both Opec and non-Opec producers, is likely to offset a recovery in demand.
The nature of our underweight position in technology graphically illustrates the forward-looking valuation approach. Thanks to the long unwinding period after the boom of 1999/2000, recovery in these sectors is likely to be delayed. The current technology cycle is far from normal. Yet, following the 28% bounce in the Nasdaq Index, the September low and continuing dull trading, overall valuations are excessive. This applies in particular to leading blue chips, like Cisco, Intel and Microsoft, which are way ahead of the game.
Our caution extends to semiconductors and telecom equipment companies, which are set to bring up the rear of the recovery queue. Better value can be found among software companies, with lesser known mid caps, particularly repaying research efforts.
Making money in the US stock market in the current year is unlikely to be an easy or straightforward exercise. But the efforts entailed in carrying out thorough research and in acting on well-founded convictions are likely to bear fruit.
In conclusion, this is no vanilla market recovery and anything but a targeted investment strategy is unlikely to yield strong returns.
Enron has set off serious doubts about company accounts in general.
At the very least, 2002 promises to be a great year for traders and hedge funds.
Companies have responded to tougher trading conditions by reducing inventories.
Clarke replacing Balkham
'Deep-dive analysis of client behaviour'
Ways to mitigate April’s increases
The best equity income funds examined