One of our most experienced international fund managers remarked in mid-January that there is a para...
One of our most experienced international fund managers remarked in mid-January that there is a paradox about investing in US equities: when US share prices fall, it is usually shrewder to invest in US equities rather than take refuge in European or Asian equities. He was backing up the market adage that when America sneezes the rest of the world catches a cold.
Why is this the case? Most probably because of its status as the world's largest economy, home to over half the world's equities by market value, as well as being one of the most liquid capital markets in the world.
The last point is significant, as most portfolio managers will emphasise the importance of being able to buy and sell large equity positions without fear of the barriers to trade created by an illiquid market. As non-US equity markets can be less liquid, it follows that share prices can be squeezed both upwards and downwards to a greater extent according to buying or selling pressure from investors.
Looking at 2005, equity returns were stronger outside the US. Most commentators would agree that investors are still enjoying the secondary effects of the abundant liquidity created by the historically low level of interest rates in most economies from 2001 to 2004.
Interestingly, it is emerging markets that revealed some of the strongest equity returns in 2005. Lack of liquidity in these markets is often used as a potential reason to be cautious in these markets. The fact emerging markets did so well could be an expression of the abundant liquidity in global capital markets.
So far so good, but what about prospects for 2006? One exercise is to look at the relative valuations of the US and European equity markets, both as they stand today and how they stood a year ago. In sterling terms, the Dow Jones Industrials index returned 13.8%, while the S&P 500 Composite index returned 17.3% in 2005. In US dollar terms the S&P 500 Composite index returned 4.9%.
Early estimates put earnings growth for the S&P 500 Composite as a whole at around 14% over the same period. By the same token, returns for the MSCI Europe ex-UK index were 24.5% in sterling terms, but earnings estimates for 2005 are estimated to be around 12%. In other words, the valuation differential between US and European equities as expressed by the price to earnings ratio, will have narrowed significantly as we begin 2006.
As we end January 2006, investors have begun to fret about the high price of oil and whether recent earnings disappointments by some US companies for the fourth quarter of 2005 might set a worrying trend for 2006. There is also the fact that many non-US investors remain underweight US equities, relative to their weighting within global equities.
Were there to be a surprise winner in 2006, much as Japanese equities surprised investors with strong returns in 2005, it could well be US equities.
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